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Content Page No.

1. Basic concept 3
2. Budget 12
3. Pricing 19
4. Marginal costing 26
5. Absorption costing 34
6. Standard costing 38
7. Balance scorecard 44
8. Benchmark 48
9. Activity base costing 51
10. Relevant costing 63
11. Linear programming 66
12. Throughput accounting 68
13. Transfer pricing 70
14. Learning curve 75
15. Life cycle costing 79
16. Value analysis 84
17. Target costing 90
18. JIT 96
19. MRP 102
20. ERP 105
21. Service sector 107
22. TQM 110
23. Assignment 119
24. Simulation 120
25. Network analysis 122
26. Transportation 128
27. Short notes 131
28. Uniform costing 142
29. Short questions 146
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Basic concept

1. Define Cost & Management Accountancy

Cost is a measurement, in monetary terms, of the amount of resources require for the purpose of
production of goods or rendering services.

ICAI defines Management Accountancy as the application of accounting and costing principles,
methods and techniques in the ascertainment of costs and the analysis of savings as compared with
previous experience or standards.
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CIMA defines Management Accounting as “the establishment of budgets, standard costs and actual
costs of operations, processes, activities or products, and the analysis of variances, profitability or
the social use of funds.”

2. What is Management Control system? State three essential characteristics of a Sound

management Control system. (4 marks)

Answer
Management control system is the process by which the managers assure that resources are
obtained and used effectively and efficiently in the accomplishment of organization objectives. A set-
up by which the managers can ensure that the objective is known as the management control
system. This system is really concerned with management’s implementing decisions made under
strategic planning i.e., the process of deciding on objective of organisation, on change in these
objectives and on policies that are to govern the acquisition, use disposition of the resources.

The following are the leading characteristics of management control system :

1. It is concerned with all types of forecasts like marketing, production, finance etc. for the next
year or even two or three years
2. It is continuous exercise, even as work proceeds, plans are charged as the experience gained.
3. Management must itself engage in the task and work on the information continuously collected.
4. Research, Marketing Advertising, Production, HR Policies must be adjusted continuously.
5. The activity is regular, discipline and usually has an annual horizon.
6. All employees are involved and the information has to be property organised and channelised.
7. Appraisal is constant and easy to understand. .
8. The emphasis is on both planning and control as more or less a simultaneous activity.
9. Management Control particularly involves middle managers who are engaged to take actions
that are in the best interest of the organisation.

3. Outline the key attributes of an operational database (4 marks)

(1) Consistency of related information elements: Operating personnel are alert for information
that is in consistent with information they already possess. If information from different source
about the transaction is consistent, this information, as well as the information system, has
greater validity.
(2) Timeliness: of transactions information and of managerial reports. Because of simultaneous
updating of all records affected by a transaction and the frequent use of on-line transactions
entry, database records are more likely than conventional files.
(3) Back-up: detail provided by inquiry capability: Operations personnel refer to backup details to
answer customer questions about account status. Also all managers can cite many instances
when they have received highly summarized unexplained circumstances such as a production
cost variance. Frequently the data needed exists in the computer system.
(4) Data sharing: The sharing of a large pool of operations data among multiple user
departments is possible with a database. Without a database, information about other
department’s activities probably would be available only several days after the end of each
accounting period, if at all.
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(5) A database should be maintained with costs appropriately coded and classified so that
relevant cost information can be extracted to help managers make better decisions. Future costs
rather than past costs are required for decision making.

4. State the characteristic of a database created for operational control and decision making.
(3 marks)
Answer
(i) There should be a file structure that facilitates the association of one internal record with other
internal records.
(ii) There should be cross functional integration of files.
(iii) Independence of program / data file for ease of updating and maintenance of data base.
(iv) There must be common standards throughout data definitions & record formats..
(v) A data dictionary should be available.

5. Explain clearly the terms Responsibility Centre, Cost Centre, Profit centre. (4 marks)

Answer
Responsibility Centre : A resistibility centre is an organisational unit headed by a responsible
person or manager. In case of responsibility centre only those costs are considered for which the
manager of the responsibility centre is accountable. It is a system of control by delegating authority
and locating responsibility for costs. Responsibility centres can be divided into three categories viz.,
Cost centres, Profit centres and Investment centres.

Cost or Expense or Budget Centre or Cost Object: It is defined as a location, person or an item of
equipment or a group of these for which cost may be ascertained and used for the purpose of cost
control. Cost Centres are of two types : impersonal and personal. An Impersonal Cost Centre
consists of a location or equipment or group of these. For example, a Cost Centre determined
according to location may be an area or region of sales, a depot or warehouse. Such cost centres
are mainly related to selling and distribution costs. A manufacturing concern may have number of
Cost Centres - producing Cost Centre & Service Cost Centre. The measurement of output of a cost
center is known as Cost Unit, e.g. MWH for a Electricity Department.

Profit Centre : A production / Service unit of an organisation headed by an individual fully

responsible for all costs, revenues and profitability of its operations is known as a profit centre. The
individual is authorized to plan and look after production, financial and accounting activities of the
centre. A concern may be divided into a number of profit centre or strategic business unit.
Generally a department is considered as a profit centre if it’s total production is in high demand by
the outsiders. Hence a profit centre is empowered to charge the sales price for an inter-division
transfer. A Profit Centre can not distribute its profit without the consent of Investment Centre.

Investment Centre : A centre whose managers are normally accountable for sales revenue and
expenses but in addition they are also responsible for some capital investment decisions and are
thus able to influence the size of the investment. Return on investment (ROI) and Residual Income
(RI) are usually used to evaluate the performance of investment centres.

6. Given an appropriate cost unit for each of the following service sectors: (1 mark each)
(i) Hotel (ii) School
(iii) Hospital (iv) Accounting firm
(v) Transport (vi) Staff Canteen
(vii) Machine maintenance (viii) Computer Department

Answer
Service Sector Cost Unit
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(i) Hotel Bednights available or occupied
(ii) School Student hours or no. of full time students
(iii) Hospital Patient-day / Room-day
(iv) Accounting firm Client hours
(v) Transport Passenger-Kms, or Quintal km or tonne-km
(vi) Staff Canteen No. of meals provided or no. of staff
(vii) Machine maintenance Maintenance hours to user departments
(viii) Computer Department C Computer time to user departments.

7. Merit of profit centre (3 marks)

1. It makes its managers responsible to earn the budgeted amount of profit during a period.
2. Under profit centre concept the whole organisation is dividend into a number of divisions, the
performance of each division is measured in terms of both the income and the costs.
3. Managers in each division have freedom in making decisions. They need not obtain approval
from corporate headquarters for every expenditure.

8. Disadvantages of profit centres: (4 marks)

1. Division may compete with each other and may take decisions to increase profits at the
expenses of other divisions thereby overemphasizing short term results.
2. It may adversely affect co-operation between the divisions and lead to lack of harmony in
achieving organizational goals of the company.
3. There may be higher cost of common activities following decentralized structure.
4. Top management loses control by delegating decision marking to divisional managers.
5. It may under utilise corporate competence.
6. It leads to complication associated with transfer pricing problems.
7. It becomes difficult to identify and define precisely suitable profit centres.
8. It confuses division’s result with manager’s performance.

9. What are the pre-requisites for Responsibility Accounting System ? (4 marks)

Answer:
(i) The area of responsibility and authority of each responsibility centre should be clearly defined.

(ii) The set of goals for each manager of responsibility centre should be clearly stated.

(iii) The performance report of a responsibility centre should include only the revenues, expenses
profits and investments which are to be controlled by the executives of that centres.

(iv) The items which may require management’s attention like variance should be highlighted in the
performance report of each responsibility centre.

(v) The help of managers of responsibility centre is required while establishing the goals.

10. Distinguish between Cost Control and Cost Reduction. (4 marks)

Answer
Cost Control is the guidance and regulation by executive action of the costs of operating an
undertaking according to the functional budgets. It includes planning, communication, motivation,
reporting and decision making.
Cost reduction may be defined as the achievement of real and permanent reduction in the unit cost
of the products manufactured.
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The following distinction may be made between them:
(i) Cost Control implies setting up for norms or targets through budgets, standards forecasts etc.
and efforts made to achieve them. Cost reduction donates systematic efforts to improve the
targets set by better designs, improved planning and organization.
(ii) In Cost Control, Standards or Budgets once set up are accepted and not changed whereas in
the case of cost reduction the very standards/budgets are changed and efforts are made to
improve upon them.
(iii) Cost control is a basically preventive function where by the result/goal is achieved by keeping
to a standard. Cost reduction is a corrective action and continuous efforts are made to
correct or adjust the present standards or budgets.
(iv) Cost reduction has dynamic approach with a much wider application. It covers product
design, factory layout, production control etc. whereas Cost Control is not so dynamic having
limited scope of staying within the predetermined standards and budgets.

(v) Cost reduction requires some capital expenditure, but it is not required in case of Cost
control.
(vi) Cost control is temporary bur cost reduction is permanent.

11. Classify the following items under the more appropriate category: CC implies cost Control Or
CR implies Cost Reduction.
(i) Costs exceeding budgets or standard are investigated.
(ii) Preventive function
(iii) Corrective function
(iv) Measures to standardize for increasing productivity
(v) Provision of proper storage facilities for materials.
(vi) Continuous comparison of actual with the standards set.
(vii) Challenges the standards set
(viii) Value analysis (4 Marks)

Answer
Classification of items under cost reduction/ cost control
SL.No Item Category
. Cost Control (CC)
Cost Reduction (CR)
(i) Costs exceeding budgets or standards are investigated CC
(ii) Preventive function CC
(iii) Corrective function CR
(iv) Measures to standardize for increasing productivity CR
(v) Provision of proper storage facilities for materials CC
(vi) Continuous comparison of actual with the standards set CC
(vii) Challenges the standards set CR
(viii) Value analysis CR
12. Pick out from each of the following items, costs that can be classified under ‘committed fixed costs’
or ‘discretionary fixed costs”.
(i) Annual increase of salary and wages of administrative staff by 5% as per agreement
(ii) New advertisement for existing products is recommended by the Marketing Department for
achieving sales quantities that were budgeted for at the beginning of the year.
(iii) Rents paid for the factory premises for the past 6 months and the rents payable for the next
six months. Production is going on in the factory.
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(iv) Research costs on a product that has reached \maturity’ phase in its life cycle and the
research costs which may be needed on introducing a cheaper substitute into the market for
facing competition.
(v) Legal consultancy fees payable for patent rights on a new product Patenting rights have been
applied for.

Solution:

Committed Fixed Cost Discretionary Fixed Cost

(i) Salary and Wage increase. (ii) New Advertisement Cost.
(iii) Rents payable for the next 6 months. (iv) Research Cost for substitutes.
(v) Legal Fees for filing for patent right.

13. List out any four operation research techniques used for cost control in an organisation. (4 marks)

Answer
The following are some of the O.R. techniques applied for cost control in an organisation :

i. Linear Programming
ii. Inventory Control
iii. Probabilistic Models
iv. Critical Path Analysis

14. What are the essential requisites of management control reports? (4 marks)

Answer
(i) A timely report initiates prompt corrective action.

(ii) Regular and in appropriate frequency.

(iii) These should be control – oriented drawing attention to exceptions.
(iv) Must contain adequate information; not too much nor too little.
(v) These should be unambiguous.
(vi) Pin – point deviations from norms or standards.
(vii) The statement should provide comparative figure ..
(viii) These should be analytical with adequate details but concise, with only key figures and facts.
(ix) Management control reports consists information : pertinent, understandable and correct.

15. Name any 10 tools and techniques for ‘Cost Reduction’. (5 marks)

Solution:

Tools and techniques for cost reduction are as under-

(i) Budgetary Control and Standard Cost

(ii) Value Analysis
(iii) Simplification and Variety Reduction
(iv) Economic Batch Quantity (E.B.Q.)
(v) Coding and Classification
(vi) Improvement in Design
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(vii) Substitute Material Utilisation
(viii) Operational Research
(ix) Quality Control
(x) Production Planning and Control
(xi) Inventory Control
(xii) Purchase Scheduling
(xiii) Job evaluation and merit voting.
(xiv) Training and Development
(xv) Business Forecast
(xvi) Market Research

16. Distinguish between ‘Committed Fixed Costs’ and ‘Discretionary Fixed Costs’. (5 marks)

Answer
Committed fixed costs, are those fixed costs that arise from the possession of: (i) a plant, building
and equipment (e.g. depreciation, rent, taxes, insurance premium etc) or (ii) a functioning
organisation (i.e. salaries of staff). These costs remain unaffected by any short –run actions. These
costs are affected primarily by long – run sales forecasts that, in turn indicates the long – run
capacity targets. Hence careful long range planning, rather than day – to – day monitoring , is the
key to managing committed costs.

Discretionary fixed costs,(sometimes called managed costs or programmed costs). These costs
have two important features:
(i) They arise from periodic (usually yearly) decisions regarding the maximum outlay to be
incurred, and
(ii) They are not tied to a clear cause – and – effect relationship between inputs and outputs.
Examples of discretionary fixed costs includes – advertising, public relation, executive
training, teaching, research, health care etc. these costs are controllable.

17. Discuss how control may be exercised over discretionary costs. (4 marks)

Answer
To control discretionary costs control points / parameters may be established. But these points need
to be divided individually. For research and development function to control discretionary costs,
dates may established for submitting major reports to manager. For advertising and sales promotion,
such costs may be controlled by pre-setting targets. In the case of employees benefits, discretionary
costs may be controlled by calling a meeting of employees union and making them aware that the
company would meet only the fixed costs and the variable costs should be met by them.

18. Pick out from each of the following items, costs that can be classified under ‘committed fixed costs’
or ‘discretionary fixed costs’.
(i) Annual increase of salary and wages of administrative staff by 5% as per agreement
(ii) New advertisement for existing products is recommended by the Marketing Department for
achieving sales quantities that were budgeted for at the beginning of the year
(iii) Rents paid for the factory premises for the past 6 months and the rents payable for the next
six months. Production is going on in the factory.
(iv) Research costs on a product that has reached ‘maturity’ phase in its life cycle and the
research costs which may be needed on introduction a cheaper substitute into the market for
facing competition.
(v) Legal consultancy fees payable for patent rights on a new product. Patenting rights have
been applied for. (5 Marks)
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Answer
Committed Fixed Cost Discretionary Fixed Cost
(i) Salary and wage increase (ii) New Advertisement Cost
(iii) Rents payable for the next 6 months (iv) Research cost for substitutes
(v) Legal fees for patent right.

19. “Costs may be classified in a variety of ways according to their nature and the information needs of
the management.” Explain. (4 marks)

Answer
Cost classification is the process of grouping costs according to their characteristics. Costs are
classified or grouped according to their common characteristics. Costs may be classified according
to elements, according to functions or operations, according to their behavior, according to
controllability or according to normality.

The break up of the aggregate costs into relevant types, is an essential pre – requisite of decision
making as well as of controlling costs. Classification of costs on different basses is thus necessary
for various purposes. For the purpose of decision making and control, costs are distinguished on the
basis of their relevance to different type of decisions and control functions. The importance of
distinguishing costs as direct or indirect lies in the fact that direct costs of a product or an activity can
be accurately allocated while indirect costs have to be apportioned on the basis of certain
assumptions. This is so because direct costs are controllable at the operation able level whereas
indirect costs are not amenable to such control.

20. What is meant by Cost – plus pricing? (4 marks)

Answer
It is the most widely used method of pricing a product as it ensures that the selling price is greater
than the total cost of a product.
Under cost plus pricing the selling price of the product is determined by adding a percentage of mark
– up to the estimated unit cost of the product.
The unit cost of the product can be determined by using different method viz., total cost;
manufacturing cost or variable or incremental cost. The percentage of mark-up to be added to
estimated cost also varies and depends upon the cost figure used. For example, if total cost is used,
the mark up will be added to provide an acceptable amount of profit.
Alternatively, if total manufacturing cost is used, the ‘plus’ that is added must be sufficient to cover
non – manufacturing overheads and to provide an acceptable profit per unit.
21. “Cost may be classified in a variety of ways according to their nature and information needs of the
management.” Discuss. (4 marks)

Answer
Costs can be classified in the following manner :
i. By element : Under this classification costs are classified into (a) Direct costs and (b) Indirect
costs according to elements viz., materials, labour and expenses.
ii. By function : Hence costs are classified as : production cost; administration cost; selling costs;
distribution cost; research cost; development cost, etc.
iii. By Behavior : According to this classification costs are classified as fixed; variable and semi
variable costs. Fixed costs can be further classified as committed and discretionary.
iv. By controllability : Costs are classified as controllable and non-controllable costs.
v. By normality : Under this classification costs are segregated as normal and abnormal costs.
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22. State the type of cost in the following cases : (Marks 4)

(i) Cost associated with the acquisition and conversion of material into finished product.
(ii) Cost arising from a prior decision which cannot be changed in the short run.
(iii) Increase in cost resulting from selection of one alternative instead of another.
(iv) Rent paid for a factory building which is temporarily closed.

Answer

Cases Type of Cost

Cost associated with the acquisition and conversion of Product Cost
material into finished product.
Cost arising from a prior decision which cannot be changed Committed Cost
in the short run.
Increase in cost resulting from selection of one alternative Differential/Incremental Cost
instead of another.
(iv) Rent paid for a factory building which is temporarily closed. Shut Down Cost

23. Briefly identify the areas of cost reduction at the product design stage. (4 marks)

Answer.
The impact of a cost reduction decision made at the designing stage can be revealed at every stage
of manufacture. Before making new design, a design policy has to be settled by top management.
The design policy may be directed towards objectives such as

i. Low cost and functional efficiency

ii. Widest possible application
iii. Quality and life, and
iv. Appearance.

Any attempt to achieve cost reduction through design economies may come into conflict with the
existing design. So a firm policy of design has to be settled by overcoming the conflicts. Potential
areas for cost reduction in the field of design are :
i. Introduction of new designs
ii. Improvement in existing designs, and
iii. Standardization and simplification.

24. Discuss the scope of cost reduction in the area of works services. (4 marks)

Answer
The scope for cost reduction in the area of works service may be discussed as under :

(i) Keeping record of consumption of power and coal to analyse the potential of cost reduction.

(ii) A detailed study of the influence of power factor and maximum demand upon electricity
charges and avoidance of waste by power generations, etc.
(iii) Boiler house instrumentation as an aid efficient utilisation of coal.

(iv) Introduction of preventive maintenance plans to avoid frequent breakdown and the resultant
loss of production.

(v) Consideration of maintenance cost bill vis-à-vis plant replacement cost to effect long run
economies.
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(vi) Introduction of quality control techniques to ensure the maintenance of quality of products.

(vi) Study and review of clerical procedures and systems to avoid duplication of work, elimination
of unnecessary reports and making effective use of the information recorded for formulation
policies, planning and control.

25. Briefly explain the terms “product cost” and “period cost”. (4 marks)

Answer
Product cost
Product costs are those costs which are associated with and directly identifiable with the product. In
orders, costs which assigned to the product are product costs. Under marginal costing variable
manufacturing costs and under absorption costing total manufacturing costs constitute product costs.
A product cost is thus the sum of the fixed & variable costs assigned to a product for specific
purpose.

Period cost
Period costs are costs that are reported as expenses of the period in question. All non manufacturing
costs such as general and administrative expenses, selling and distribution expenses are examples
of period costs. In marginal costing, fixed factory overheads are treated as period costs but under
absorption costing they are considered as product costs.

26. “The diverse use of routinely recorded cost data give rise to a fundamental danger information
prepared for one purpose can be grossly misleading in another context.” Discuss to what extent the
above statement is valid and explain you conclusion. (4 marks)

Answer
A database should be maintained with costs appropriately coded and classified so that relevant cost
information can be extracted to help managers make better decisions.
Future costs rather than past costs are required for decision making. Therefore, costs extracted
from the database should be adjusted to make it relevant for that purpose.
For example, consider a situation where a company is negotiating a contract for the sale of one of its
products with a customer in a overseas country which is not part of the normal market. If the
company has temporary excess capacity and the contract is for 100 units for the month only, then
the direct labour cost will remain the same irrespective of whether the contract is undertaken or not.
The direct labour cost will therefore be irrelevant. Let us now assume that the contracts for 100 units
per month for three years and the company have excess capacity. For long-term decisions, direct
labour will be irrelevant cost because if the contract is not undertaken, direct labour can be deployed
or made redundant undertaking the contract will result in additional labour costs.
Budget
Budgets have two main roles:
(1) They act as authorities to spend, that is, they give authority to budget managers to incur
expenditure in their part of the organisation.
(2) They act as comparators for current performance, by providing a yardstick against which
current activities can be monitored, and they may be used as targets to motivate managers.

1. What is a budget? (4 marks)

A budget could be defined as ‘a quantified plan of action relating to a given period of time’. For a
budget to be useful it must be quantified. For example, it would not be particularly useful for the
purposes of planning and control if a budget was set as follows: ‘We plan to spend as little as
possible in running the printing department this year’; or ‘We plan to produce as many units as we
can possibly sell this quarter’.
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These are merely vague indicators of intended direction; Budgeted revenue expenditure for the
printing department this year is 60,000’; & ‘Budgeted production for the quarter is 4,700 units.
The quantification of the budgets has provided:
(a) a definite target for planning purposes; and
(b) a yardstick for control purposes.

The thrust of this approach is that the budget provides an internal benchmark against which
performance can be evaluated. If the department or business achieves its budget turnover and/or
profit for the period that it is deemed to be performing well. Conversely, if it fails to achieve budget
then it is deemed to be performing badly.

2. Essential features: (3 marks)

 A budget may be expressed in terms of money or quantity, or both
 It should be developed prior to the period during which it is to operate,
 It is set for a definite period, and
 Before its preparation, the objective to be attained and the policy to be pursued to achieve that
objective are required to be laid down.
 Budgeting lays emphasis on the necessity for advance decision on future course of action.

3. Objective : (4 marks)
(a) A budget is a blue print of the desired plan of action or operation. Plans covering the entire
organisation and all its functions like purchase, production, sales, financial management,
research and development are expressed through budgets.
(b) The budget serves as a declaration of policies and also defines the objective for executives at
all levels of management.

(c) Budgets provide a means of co-ordination of the business as a whole. In the process of
establishing budgets, the various factors like production capacity, sales possibilities, and
procurement of material, labour, etc. are balanced and co-ordinates so that all the activities
proceed according to the objective.
(d) Budgets are means of communication. Complex plans laid down by the top management are
passed on to those who are responsible for putting them into action.
(e) Budgets facilitate centralized control with delegated authority & responsibility. Grouped
according to the responsibilities of different executive levels, they facilitate decentralization of
work.

(f) Budgets are instruments of managerial control by means of which the management can
measure performances in every part of the concern and take corrective action as soon as any
deviations from the budgets come to light.

4. The preparation of budgets : (4 marks)

The process of preparing and using budgets will differ from organisation to organisation. However,
the key requirements in the design of a budgetary planning and control process are:
a. Co-ordination: the budget committee
b. Participative budgeting i.e. Flexible budget of each department
c. Information: the budget manual. It is a collection of documents that contains key information
for those involved in the planning process.
d. Early identification of the Principal Budget factor (PBF)
e. The interrelationship of budgets i.e. the Functional budgets
f. The master budget

5. The Budget manual: (5 marks)

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Effective budgetary planning relies on the provision of adequate information to the individuals
involved in the planning process. Many of these information needs are contained in the budget
manual. A budget manual is a collection of documents that contains key information for those
involved in the planning process. Typical contents could include the following:
a) An introductory explanation of the budgetary planning and control process, including a statement
of the budgetary objective and desired results.
b) A form of organisation chart to show who is responsible for the preparation of each functional
budget and the way in which the budgets are interrelated.
c) A timetable for the preparation of each budget. This will prevent the formation of a ‘bottleneck’
with the late preparation of one budget holding up the preparation of all others.
d) Copies of all forms to be completed by those responsible for preparing budgets, with
explanations concerning their completion.

e) A list of the organization’s account codes, with full explanations of how to use them.
f) Information concerning key assumptions to be made by managers in their budgets, for example
the rate of inflation, key exchange rates, etc.

6. Early identification of the principal Budget factor (3 marks)

The principal budget factor is a constraint, around which the budget is constructed. It is the factor
that limits the activities of the organisation. The early identification of this factor is important in the
budgetary planning process because it indicates which budget should be prepared first.
For example, sales volume is the principal budget factor then the sales budget must be prepared
first, based on the available sales forecasts. All other budgets should then be linked to this.
Alternatively, machine capacity may be limited for the forthcoming period and therefore machine
capacity is the principal budget factor. In this case the production budget must be prepared first and
all other budgets must be linked to this.
Failure to identify the principal budget factor at an early stage could lead to delays later on when
managers realize that the targets they have been working with are not feasible.

7. The interrelationship of budgets (3 marks)

The critical importance of the principal budget factor stems from the fact that all budgets are
interrelated. For example, if sales is the principal budget factor this is the first budget to be prepared.
This will then provide the basis for the preparation of several other budgets, including the selling
expenses budget and the production budget.
However, the production budget cannot be prepared directly from the sales budget with-out a
consideration of stockholding policy. For example, management may plan to increase finished goods
stock in anticipation of a sales drive. Production quantities would then have to be higher than the
budgeted sales level. Similarly, if a decision is taken to reduce the level of material stocks held, it
would not be necessary to purchase all of the materials required for production.
8. Fixed & Flexible Budget (4 marks)

Budgets show the planned costs and revenues which an organisation expects in a future period.
They can be divided into two categories.

Fixed budgets are set before the start of an accounting period, are not susceptible to change, and
are used as a plan for the future Their use is most appropriate where resources have to be tightly
controlled, as in cash control.

Fixed budgets may be set before or after the actual performance is known. If they are set after the
event, they are set on the basis of the level of activity which was actually undertaken. This allows
valid comparison to be made against the costs and revenues which were actually recorded,
facilitation operational control.
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Budget flexing can also be undertaken before activity commences, to show predicted costs/revenues
at a number of activity levels by recognizing the difference between fixed, semi-variable and variable
costs. This gives management a prior understanding of the financial consequences of a number of
possible activity levels.

Example- Seasonal products – e.g. drink industry, industries in make to order business like ship
building, Industries influenced by change in fashion, Industries which keep on introducing new
products / new designs.

9. The Master budget (2 marks)

The master budget is a summary of all the functional budgets. It usually comprises the budgeted
profit and loss account, budgeted balance sheet and budgeted cash flow statement. It is this master
budget that is submitted to senior managers for approval because they should not be burdened with
an excessive amount of detail.

10. ‘Traditional budgeting systems are incremental in nature and tend of focus on cost centers -explain
the weaknesses of an incremental budgeting system.` (5 marks)

Answer:
Incremental budgeting uses year 1 budget as the starting point for the preparation of year 2 budget.
It is assumed that the basic structure of the old budget is acceptable and that adjustments will be
made to allow for changes in volume, efficiency and price levels. The focus, therefore, tends to be on
the existing use of resources rather than on identifying objectives and alternative strategies for the
future budget period. It is argued that incremental budgeting does not question sufficiently the costs
and benefits of operating a particular resource allocation structure.

Incremental budgeting may, therefore, be argued to have weaknesses in that:

 the resource allocation is not clearly linked to a business plan and the consideration of
alternative means of achieving objectives;
 there is a tendency to constrain new high-priority activities;
 there is insufficient focus on efficiency and effectiveness and the alternative methods by which
they may be achieved;
 it often leads to arbitrary cuts being made in order to meet overall financial targets;
 it tends not to lead to management commitment to the budget process.

11. Zero base budget. (3 marks)

ZBB is defined as ‘a method of budgeting which requires each cost element to be specifically
justified, as though the activities to which the budget relates were being undertaken for the first time.
Without approval, the budget allowance is zero’.

Zero–base budgeting is so called because it requires each budget to be prepared and justified from
zero, instead of simple using last year’s budget as a base. Incremental level of expenditure on each
activity are evaluated according to the resulting incremental benefits. Available resources are then
allocated where they can be used most effectively.

The major advantage of ZBB exercises is that managers are forced to consider alternative way of
achieving the objectives of their activity and they are required to justify to activities which they
currently undertake.
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12. Steps or process involved in the process of Zero Based Budgeting: (4 marks)

1. Determination of a set of objects is the pre-requisite and essential step in the direction of ZBB
technique.

2. Deciding about the extent to which the technique of ZBB is to be applied whether in all areas
of organization activities or only in few selected areas on trial basis.

3. Identify the areas where decisions are required to be taken.

4. Developing decision packages and ranking them in order of performance.

5. Preparation of budget that is translating decision packages into practical units/items and
allocating financial resources.

13. Discuss the characteristics of zero base budgeting (4 Marks)

Answer:
Characteristics of ZBB:
(i) Manager of a responsibility center has to justify the budget allotment for his centre.
(ii) Activities are identified in decision packages.
(iii) Decision packages are ranked in order of priority
(iv) Packages are evaluated by systematic analysis.
(v) Decision packages are linked with corporate objectives, which are clearly laid down.
(vi) Available resources are allotted for different options in order to ensure optimal results.

14. ZBB is superior to traditional budgeting :

 It provides a systematic approach for evaluation of different activities.

 It ensure that the function undertaken are critical for the achievement of the objectives.
 It provides an opportunity for management to allocate resources to various activities after a
through–put cost benefit analysis.

 It helps in the identification of wasteful expenditure and then their elimination.

 If facilitates the close linkage of departmental budgets with corporate objectives
 It helps in the introduction of a system of Management by Objectives.

15. Advantages of ZBB (4 marks)

(i) It helps a systematic evaluation of different activities and ranks them in order of preference for
allocation of scare resources.

(ii) Every functions of the organisation are critically analysed for the achievement of its objectives
so that it can be performed in the best way.

(iii) It provides an opportunity to the management to allocate resources for various activities only
after having a through cost- benefit analysis.

(iv) The area of wasteful expenditure can be easily identified and eliminated.

(v) Departmental budgets are closely linked with corporate objectives.

(vi) The technique can also be used for the introduction and implementation of the system of
‘management by objective’.
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16. Limitations of ZBB (2 marks)
(i) Various operational problems are likely to be faced in implementing the technique.
(ii) The full support of top management is required.
(iii) It is time consuming as well as costly
(iv) It requires proper trained managerial staff

17. ZBB in practice (4 marks)

ZBB has been adopted more widely in the public sector than the private, although examples of
organisations regularly adopting a full ZBB approach are rate. Full-scale ZBB is so resource-
intensive that critics claim that its advantages are outweighed by its implementation costs.

However, it is not necessary to apply ZBB to the whole of an organisation; benefits can be gained
from its application to specific areas. For example, in the public sector, a decision could be made
regarding the overall size of the childcare budget, and ZBB could be applied to allocate resources
within the particular field; similarly, in a business organisation, ZBB could be applied to individual
divisions on a rotational basis. This selective application ensures that a through reappraisal of
activities is undertaken regularly, but not so regularly that the process itself is a major drain on
organisational resources.

Notwithstanding the criticisms, the main plank of the ZBB approach  the rejection of past budgets
as a planning baseline  is being increasingly accepted.

18. In each of the following independent situations, state with a reason whether ‘Zero Based Budgeting’
(ZBB) or ‘Traditional Budgeting’ (TB) would be more appropriate for year II. (2 marks each)

A company producing a certain product has done extensive ZBB exercise in year I. The activity level
is expected to marginally increase in year II.

(i) The sales manager of a company selling three products has the intuitive feeling that in year II,
sales will increase for one product and decrease for the other two. His expectation cannot be
substantiated with figures.

(ii) The top management would like to delegate responsibility to the functional managers for their
results as from year II.

(iii) Resources are heavily constrained and allocation for budget requirements is very strict.

Answer
(i) The company has done extensive exercise in year-I that can be used as a basis for
budgeting in year-II by incorporating budget allowance in costs & revenue at expected activity
level. Hence, Traditional Budgeting would be more appropriate in year-II.

(ii) In Traditional Budgeting system budgets are prepared on the basis of previous year’s budget
figures with budget allowance and corresponding adjustment in the cost and prices. But under
Zero Base Budgeting (ZBB) the estimations or projections are converted into figures. Since,
sales manager is unable to substantiate his expectations into figures so Traditional Budgeting
would be preferred against Zero Base Budgeting.

(iii) Zero Base Budgeting would be appropriate as ZBB allows top-level strategic goals to be
implemented into the budgeting process by tying them to specific functional areas of the
organization, where costs can be first grouped, then measured against previous results and
current expectations.
 17
(iv) Zero Base Budgeting allocates resources based on order of priority, as computed on basis of
cost benefit analysis. So, in this situation, Zero Base Budgeting is more appropriate method of
budgeting.

19. Rolling Budgets. (2 marks)

Rolling budgets can be particularly useful when future events cannot be forecast reliably. A rolling
budget is defined as ‘a budget continuously updated by adding a further accounting period (month or
quarter) when the earliest accounting period has expired. Its use is particularly beneficial where
future costs and/ or activities cannot be forecast accurately.’
For example a budget may initially be prepared for January to December, year 1. At the end of the
first quarter, i.e., at the end of March, year 1, the first quarter’s budget is deleted. A further quarter is
then added to the end of the remaining budget, for January to March, year 2. the remaining portion
of the original budget is updated in the light of current conditions. This means that managers have a
full year’s budget always available and the rolling process forces them to continually plan ahead. A
system of rolling budgets is also known as continuous budgeting.

20. Performance Reporting at various levels of management: (4 marks)

A major part of the management account’s job consists of preparing reports to provide information
for purposes of control and planning. The important consideration in drawing up of reports and
determining their scope are the following:
1. Significance 2.Timeliness 3. Accuracy 4. Appropriateness 5. Discrimination 6.Presentation
21. “Because a single budget system is normally used to serve several purposes, there is a danger that
they may conflict with each other”. Do you agree? Discuss (Marks 4)

Answer
A single budget system may be conflicting in planning and motivation, and planning and
performance evaluation roles as below:

(i) Planning and motivation roles may not be achieved may be appropriate to motivate maximum
performance but they are unsuitable for planning purposes. For these, a budget should be a set
based on easier targets that are expected to be met.
(ii) Planning and performance evaluation roles – For planning purposes budgets are set in advance
of the budget period based on an anticipated set of circumstances or environment.
Performance evaluation should be based on a comparison of active performance with an
adjusted budget to reflect the circumstance under which managers actually operated.
22. Write short note on ‘Zero Base Budgeting as an approach towards productivity improvement.’
(4 marks)
Solution
Zero Base Budgeting (ZBB) is an expenditure control device where without reference to the past
budget figures or achievements each division head has to justify the requirement of funds for each
head of expenditure and prepare the budget accordingly.
ZBB provides a basis for evaluating decision package on basis of cost-benefit analysis. It focuses
attention on output in relation to value of money. It reduces inefficiency and achieves high level of
effectiveness. It can be applied to cost reduction programmes. Scarce resources can be utilised
effectively. Ineffective activities are eliminated and duplicate activities are easily identified. Thus
wasteful expenditure is reduced or eliminated fully.
It leads to increase in staff participation creating greater motivation and job satisfaction. All these
aspects will ultimately result in greater productivity of the resources and organization performance by
way of higher profit or lower costs.

23. What are the various formulae used in calculating budget ratios? (6 marks)
 18
Answer
1. Efficiency Ratio = (Standard hours ÷ Actual hours) × 100
2. Activity Ratio = (Standard hours ÷ Budgeted hours) × 100
3. Calendar Ratio = (Available working days ÷ budgeted working days) × 100
4. Standard Capacity Usage Ratio (Budgeted hours ÷ Max. possible hours in the budgeted
period) × 100
5. Actual Capacity Usage Ratio = (Actual hours worked + Maximum possible working hours in a
period) × 100
6. Actual usage of Budgeted Capacity Ratio = (Actual working hours ÷ Budgeted hours) × 100

24. Define the following:

(i) Maximum capacity (theoretical capacity)
(ii) Practical capacity
(iii) Normal capacity
(iv) Principal budget factor
(The first there relate to a manufacturing plant) (4 Marks)

Answer
(i) Maximum Capacity = Maximum no. of days in a period x no. of workers or Maximum no. of
hours x no. of workers or, The maximum no. of units that can be, produced by a
manufacturing facility in a certain period.
(ii) Practical Capacity = Maximum capacity (minus) Sundays, holidays, normal maintenance &
idle time
(iii) Normal Capacity = Average of past 3 years’ normal performance excluding abnormal data
(iv) Principal budget factor = The factor that limits the activities of the functional budgets of the
organization.

25. Write short note on performance budget. (4 marks)

Performance Budgeting provide a meaningful relationship between estimated inputs and expected
outputs as an integral part of the budgeting system. ‘A performance budget is one which presents
the purposes and objectives for which funds are required, the costs of the programmes proposed for
achieving those objectives, and quantities data measuring the accomplishments and work performed
under each programme. Thus PB is a technique of presenting budgets for costs and revenues in
terms of functions. Programmes and activities are correlating the physical and financial aspect of the
individual items comprising the budget.
Pricing Techniques
Pricing is primarily the top management's exercise in Profit Planning by Profit center. The necessity
for pricing decision may arise when
(i) a new product is to be placed in the market ( Penetration or skimming or normal ),
(ii) market cannot be penetrated at existing price or there is customers' resistance to the existing
price,
(iii) quotations or bids are to be made for the products or offers are received for purchase at a
specific price, and
(iv) some products are yielding profits lower than expected.

(v) for inter departmental transfer, i.e. transfer pricing.

The basic four parameters of pricing are (2 marks)
1. Nature of product 2. Market condition
3. Strategies of competitors 4. Government Policies

The general guidelines to be used in adopting a pricing policy are as under: (3 marks)
 19
(i) The pricing policy should encourage optimum utilization of resources.
(ii) The pricing policy should work towards a better balance between demand and supply.
(iii) The pricing policy should promote exports.
(iv) The pricing policy should serve as an incentive to the manufacturers to maximize production by
adopting improved technology.
(v) The pricing policy should avoid adverse effects on the rest of the economy.

Pricing Techniques are mainly on the basis of Absorption & Marginal :-

1. Absorption Costing or Traditional Pricing technique for establish product :
S.P.= prime cost ( actual ) + overhead recovered + mark up

2. Conversion cost method : S.P.= total cost + mark up on conversion cost

3. Standard Cost Method.
S.P.= Standard Cost + mark up
4. Marginal Cost Method .
S.P.= total variable cost + mark up on variable cost
5. Differential Cost Method .
S.P.= Differential Cost + mark up
6. Relevant cost technique
Minimum sale price = variable cost + discretionary cost + opportunity cost.
7. Learning Curve Method or Experience curve method .
S.P.= Static cost + Reducible cost + Mark up
8. Return on investment method: (ROCE or ROI)
S.P.= total cost + mark up on capital employed .
9. Activity Base Costing .
S.P.= Prime cost + overhead on cost driver + mark up
10. Life Cycle Costing :
S.P. = total cost on estimated life + mark up
11. Target Costing:
Target S.P. – Req. profit = Target cost
Short Notes:
1. List out the qualities required for a good pricing policy. (4 Marks)

Answer
Quality required for a good pricing policy:
The pricing policy plays an important role in a business because the long run survival of a business
depends upon the firm’s ability to increase its sales and device the maximum profit from the existing
and new capital investment. Although cost is an important aspect of pricing, consumer demand and
competitive environment are frequently far more significant in pricing decisions.

The pricing policy structure should:

 provide an incentive to producer for adopting improved technology and maximizing production;
 encourage optimum utilization of resources;
 work towards better balance between demand and supply;
 promote exports; and
 avoid adverse effects on the rest of the economy.

2. Describe two pricing practices in which non-cost reasons are important, when setting prices.
 20
(3 marks)
Answer.
Two pricing practices in which non-cost reasons are important when setting prices are :
(i) Price discrimination
(ii) Peak load pricing.
(iii) Price discrimination :
This is the practice of charging to some customers a higher price than that charged to other
customers. E.g. Airlines tickets for business travellers and LTC travellers are priced differently.
(iv) Peak load pricing :
This pricing system is based on capacity constraints. Under this pricing system a higher price
for the same service or product is demanded when it approaches physical capacity limits e.g.
telephones, tele-communications, hotel, car rental and electric utility industries are charged
higher price at their peak load.

3. Write short notes on Loss Leader : (4 marks)

Where a product can be enriched by a series of optional extras, which a customers of the main
product are at liberty to add on for additional advantages, the main product may be offered at a
relatively low price. If the price is set below cost, the product becomes a ‘loss leader’. It leads the
customers to buy the extras or optional advantageous spare parts which are highly price.
When a product range consists of one or more main products and a series of related optional
‘extract’, which the customer can ‘add on’ to the main product, the supplier can set a relatively low
price for the main product and a high one for the ‘extras’. Obviously, the aim is to stimulate sufficient
demand for the former to ensure the target return from sales of the latter. The strategy has been
used successfully by aircraft engine, gas turbine manufacturers ( DungFung Corpn Vs BHEL) , who
win an order with a very competitively priced main product that can only be serviced by their own,
highly priced spare parts.
Gillette did not invent the safety razor but the market strategy Gillette adopted helped to build market
share. Gillette razors were sold at 1/5 of the cost to manufacture them but only Gillette blades fitted
and these were sold at a price of 25. The blades cost only 8 to manufacture and so Gillette made
large profits once it had captured the customer.

4. Skimming Pricing Policy. (4 marks)

It is a policy of high price during the early period of a product’s existence. This can be synchronized
with high promotional expenditure and in the later years the prices can be gradually reduced. The
reasons for following such a policy are :
i. The demand is likely to be inelastic in the earlier stages till the product is established
in the market.
ii. The charging of high price in the initial periods, serves to skim the cream of the
market that is relatively insensitive to price. The gradual reduction in price in the later year will
tend to increase the sales.
iii. This method is preferred in the beginning because in the initial periods when the
demand for the product is not know the price covers in initial cost of production.
iv. High initial capital outlays, needed for manufacture, result in high cost of production.
Added to this, the manufacturer has to incur huge promotional activities resulting in increased
costs. High initial prices will be able to finance the cost of production particularly when
uncertainties block the usual sources of capital.

5. Penetration Pricing policy (4 marks)

The circumstances in which penetration policy should be adopted are as follows:
 21
(i) When the demand of the product is elastic to price, In other words, the demand of the product
increases when price is low.
(ii) When there are substantial saving on large-scale production. Here increase in demand is
sustained by the adoption of low pricing policy.
(iii) When there is threat of competition. The prices fixed at a low level act as an entry barrier to
prospective competitors.

6. Enumerate the circumstances which are favourable for the adoption of a penetrating pricing policy.
(4 marks)
Answer

Penetrating pricing policy is followed for penetrating mass market as quickly as possible through
lower price offers. This method is also used for pricing a new product. In order to popularise a new
product penetrating pricing policy is used initially. The company may not earn profit by resorting to
this policy during the initial stage. Later on, the price may be increase as and when the demand
picks up.

Penetrating pricing policy can also adopted at any stage of the product life cycle for products whose
market is approached with low initial price. The use of this policy by the existing concerns will
discourage the new concerns to enter the market. This pricing policy is also known as “stay-out-
pricing”.

Favourable circumstance :
(i) When demand of the product is elastic to price.

(ii) When there are substantial savings on large scale production. Here increase in demand is
sustained by the adoption of low pricing policy.

(iii) When there is threat of competition, the prices fixed at a low level will act as an entry barrier to
the prospective competitors.

7. Competitive pricing (4 marks)

Where a company sets its price mainly on the consideration of what its competitors are charging, its
pricing under such situation is called competitive pricing. Two types of competitive pricing are:

(i) Going rate pricing: Under this method, the firm tries to keep its price at the average level
charged by the industry. Such pricing is useful where it is difficult to measure costs.
Adoption of such pricing will not only yield fair return but would be least disruptive for
industry’s harmony. Under highly competitive conditions in homogenous product market
(such as food; raw materials and textiles) the company has no pricing decision to make.

(ii) Sealed bid pricing: competitive pricing is adopted in situations where firms compete for jobs
on the basis of bids. The bid is the firms offer price, and it is a prime example of pricing
based on the expectations of how competitors will price rather than on a rigid relation based
on the concerns own costs or demand. The objective of the firm in bidding situation is to get
the contract and therefore it tries to set its prices lower than the other bidding firms.

8. Geographic Pricing Strategies: (4 marks)

 22
In Pricing, a seller must consider the costs of shipping goods to the buyer. These costs is important
as freight becomes a larger part of total variable costs. It includes:

Point-of-Production Pricing: In a widely used geographic pricing strategy, the seller quotes the
selling price at the point of production and the buyer selects selects the mode of transportation and
pays all freight costs.

Uniform Delivered Pricing: Under uniform delivered pricing, the same delivered price is quoted to
all buyers regardless of their locations.

Zone-Delivered Pricing: Zone-delivered pricing divides a seller’s market into a limited number of
broad geographic zone and then sets a uniform delivered price for each zone.

Freight-Absorption Pricing: Under freight-absorption pricing, a manufacturer will quote to the

customer a delivered price equal to its factory price plus the freight costs that would be charged by a
competitive seller located near that customer.

9. Pricing with Time differentials: (3 marks)

Time differentials can be classified under the following heads.

(i) Clock-time differentials: The price differentials are known as clock- time Differentials
when different prices are charged for the same service or commodity at different times within
a 24 hour period.

(ii) Calendar-time differentials:

Here price differences are based on a period longer then 24 hours.

(iii) Geographical price differentials:

It refers to price differentials based on buyers location.

(iv) Consumer category price differentials: Price discriminations is frequently practiced according
to consumer categories in the case of public utilities,

10. Briefly describe the following methods of pricing:

(i) Full cost method. (3 marks)

(ii) Conversion cost method. (3 marks)
(iii) Marginal cost method (3 marks)
(iv) Standard cost method (3 marks)
(v) Efficiency curve method. (3 marks)
(vi) Return on Capital Employed method. (3 marks)

Answer
(i) Full Cost or total cost Method: In this method, selling price = prime cost + manufacturing overhead
+ administrative & selling and distribution overheads + mark up as a percentage of selling price or as
percentage of capital employed. This approach is used for cost plus contracts or for new products
that do not have established markets as well as competitive conditions.

However, it does not consider fluctuation in market demands. Further, the inclusion of fixed costs for
pricing may sometimes lead to wrong decisions with regard to the acceptance of special orders, in
such case, pricing based on Relevant costs may be profitable.
 23
(ii) Conversion cost method: This method of pricing is based on the concept that profits should be
related to the value added on raw or direct materials. So, sale price = material + conversion cost +
mark-up on conversion cost.

(iii) Marginal cost method: In this method, pricing is based on marginal (variable) costs. In special
circumstances, pricing on the basis of just recovering marginal costs plus some contribution to fixed
costs may be adopted. When a new product is being introduced to the market or a foreign market is
being explored or when the goods are of perishable nature or in similar other situations, marginal
costs based pricing can be resorted to. This method has a flexible approach and is useful in short
term pricing decisions.

(iv) Standard cost method: In organisations where standard costing system is well established,
standard costs may be the appropriate basis for pricing. The standard costs generally help in
determining fairly correct selling prices. In case of list prices and for the purpose of price quotations,
prices may be based on standard costs. However, standard costs may required to be modified to
take note of current conditions.

(v) Efficiency or Learning curve method: Pricing is done on improvements in efficiency due to
repetitive nature of operations. The time & cost reduces due to large size of production volume and
repetition of same operations. However, it may be noted that when the maximum efficiency level is
reached, there would be no saving in costs.

(vi) Return on Capital employed method: In this method, after ascertaining total costs of the product,
certain margin is added for profit. The margin is computed on desired return on capital or assets
employed. This method is useful in fixing prices of new products and the prices of those products
which use different amount of capital investment.

11. Name the pricing policy which aims at high selling price in the beginning of a product’s life cycle?

Answer : Skimming pricing. (2 marks)

12. Explain the concept of cost plus pricing. What are its advantages and disadvantages ?
(4 marks)
Answer
Cost plus pricing : In cost plus pricing, the capacity utilisation of the concern has an important
bearing and unless the same is considered on a realistic basis the determination of cost would get
vitiated.

At present, in Government sometimes Tariff Commission, Bureau of Industrial Cost & Prices (BICP)
are required to fix prices of certain products and services. They mainly adopt a system of cost plus
pricing. Similarly, Government has also set up a separate agency to fix prices for pharmaceutical
products.

The advantages and disadvantages of cost plus pricing are as under :

Advantages
(i) It is a fair method and recovery of full costs is assured under it.
(ii) It leaves out scope for any uncertainty.
(iii) After arriving at full cost, the profit percentage can be flexibly adjusted to take care of market
competition.
 24

Disadvantages :
(i) Covering full cost all the time may ignore the competition.
(ii) It can lead to a distorted price fixation unless the cost is determined in a scientific manner.
(iii) It ignore the concepts of Marginal Costing, Incremental Costing etc.
(iv) It is difficult to predetermine capacity utilization.

13. State the merits of cost – plus contracts. (3 Marks)

Answer
- It is fair method of contract price fixation. The price will cover costs and profit.
- It guarantees profit to the contractor.
- It avoids complex calculations to determine enhancement of contract price due to cost
escalation.
- It avoids delay and chances of error in estimation.
- A decision maker has to take decision. In the face of many uncertainties. He may accept a
pricing formula that seems reasonable for reducing uncertainty.
- This method of pricing does not mean that market forces are ignored. The mark up added to the
cost to reflect well established customs of trade is the guide towards competitive pricing.

14. State three application of direct costing. (3 marks)

Answer
There applications of direct costing are as follows :
(i) Stock valuation
(ii) Minimum quantity to be produced to recover pattern or mould cost.
(iii) Close down decision – like closing down of a department or shop.

15. State the general guidelines to be used in adopting a pricing policy in a manufacturing organization.
(Marks 3)
Answer
The general guidelines to be used in adopting a pricing policy are as under:
(i) The pricing policy should encourage optimum utilization of resources.
(ii) The pricing policy should work towards a better balance between demand and supply.
(iii) The pricing policy should promote exports.
(iv) The pricing policy should serve as an incentive to the manufacturers to maximize production by
adopting improved technology.
(v) The pricing policy should avoid adverse effects on the rest of the economy.

16. State the pricing strategy that you would advise in the following situations which are independent of
each other:

(i) A new product is to be launched. It has had high promotional expenditure and its demand in the
market is not known.
(ii) A new product is to be launched. It is to be mass manufactured.
 25
(iii) A product which has an external market demand is to be transferred to another division of the
same company. For the external market, variable selling costs of Rs. 10 per unit and fixed
selling costs amounting to Rs. 10 lakhs p.a. are incurred. These costs are not applicable to
divisional transfers. The divisional transfer can take up only 20% of the output produced.

(iv) A special one-time order for the use of idle capacity is offered. This order will not impact the
existing sales of the company. The product has competition in the market.

(v) There is stock of a discontinued product. It has severe competition and the product is
perishable. (7 Marks)

Solution
(i) Skimming price because demand is likely to be inelastic and high price will enable to recover
initial high promotional expenses.

(ii) Penetrating price: Charging low price to penetrate the market

(iii) External market price loss variable selling cost of Rs. 10 per unit.
Fixed selling costs are irrelevant
(iv) Variable cost+ reasonable mark-up, upto what the order can offer.
The minimum would be variable cost.
(v) If the product can be absorbed by the market at slightly less than market price, it is acceptable.
Otherwise, even a price below variable cost will be alright since the product is perishable and
future sales do not exist due to discontinuance.

17. What is Price Discrimination? Under what circumstances it is possible? (Marks 4)

Solution
Price discrimination is charging different prices with respect to customers, products, places and time.
It is possible when
 The market being capable of being segmented
 The customers is not able to resell the product at a higher price
 The competitors’ underselling is not possible.
Marginal Costing & C.V.P. analysis
The terms marginal costs and variable cost tend to be used interchangeably. In marginal costing the
variable costs are matched against the sales value for the period to highlight an important
performance measure: Contribution = Sales value - Variable Costs. It is called contribution because
it literally does contribute towards fixed costs and profit. Once the contribution has been calculated
for the period, fixed costs are deducted to determine the profit for the period.

Marginal costing values all stock items at their variable or marginal costs only. Fixed costs are
treated as period costs and are written off in full against the contribution for the period. Since the two
systems i.e. Absorption & Marginal costing value stocks differently, it follows that each will report a
different profit figure for the period.

1. CVP analysis and purposes: (Marks 4)

Profit per unit of a product depends on its selling price and cost of sales. Total profit depends on
sales volume which in turn depends inter alia on selling price. By and large cost also depends on
volume of production.
Thus, a close relationship exist between costs, volume and profit. Analysis of this relationship opens
up an interesting and useful field for the management accountant. Cost-volume-profit analysis may
be applied for profit planning, cost control, and decision making.
 26
………………………………………………………………….
The following purposes are served by analysis of cost-volume-profit relationship :
i. To forecast profit fairly accurately.
ii. To set up flexible budgets.
iii. To evaluate performance for control.
iv. To ascertain the effects of costs of changes in volume for market expansion or contraction.
v. To formulate price policies.
vi. To known the amount of overhead costs that could be charged to productions costs at various
levels of operation.

2. The assumptions of cost-volume-profit analysis : (Marks 4)

 All variables remain constant per unit.
 A single product or constant sales mix.
 Fixed costs do not change.
 Profits are calculated on variable cost basis.
 Total costs and total revenues are linear functions of output.
 The analysis applies to relevant range only.
 Costs can be accurately divided into fixed and variable components.
 The analysis applies only to short-term horizon.

3. List out the assumptions of break-even analysis. (Marks 4)

i. All costs can be easily classified into fixed and variable components.
ii. Both revenue and cost functions are linear over the range of activity under consideration .
iii. Prices of output and input remain unchanged.
iv. Productivity of the factors of production will remain the same.
v. The state of technology and the process of production will not change.
vi. There will be no significant change in the levels of inventory.
vii. The company manufactures a single product.
viii. In the case of a multi-product company, the sales mix will remain unchanged.

4. Main limitations of break-even chart. (Marks 4)

1. The variable cost line need not necessarily be a straight line because of the
possibility of operation of law of increasing costs or law of decreasing returns.
2. Similarly the selling price will not be a constant factor. Any increase or decrease in
output is likely to have an influence on the selling price.
3. When a number of products are produced, separate break-even charts have to be
drawn. This poses a problem of apportionment of fixed expenses to each product.
4. Break-even charts ignore the capital employed in business which is one of the
important guiding factor in the determination of profitability.
5. The preparation of break-even chart presumes that costs can be reliably divided into
fixed and variable component. This is very difficult in practice.
6. The break-even chart presumes that production and sales will be synchronized at all
points of time or in other words, the entire production will be sold. This may not be true in
practice.

5. Margin of Safety : (Marks 4)

BEP is a risk analysis, i.e. risk of making loss. So, when the sale is more than BE , management has
a safety feeling. This is known as margin of safety.
 27
Margin of safety is the difference between the sales or production at a particular level of activity and
the break even sales or production. A large margin of safety indicates the soundness of the business
and correspondingly a small margin of business indicates a not too-sound position. Margin of safety
can be improved by lowering the fixed cost and variable costs, increasing the volumes of sales and
production, increasing the selling prices or changing the product mix resulting into a better overall
Profit/Volume ratio. Margin of safety = Profit  P/V ratio.

6. Angle of Incidence : (Marks 4)

It is the angle of intersection between the sales & the total cost lines. It indicates the profit earning
capacity of the concern at a certain level of sales production. The larger the angle of incidence the
more is the profit earning capacity & vice versa. It also provides an indication as to what extent the
output & sales price may be varied to attain a desire level of profit. It gives an easy & clear idea to
the profitability under different levels of activities & also for different product mix & is a simple visual
aid to find out profit earning capacity without going in for any calculation. Tangent value of angel of
incidence is equal to P/V ratio which guides the volume of profit.

7. Circumstances when sale price is less than the marginal cost of the product (Marks 4)
i. When goods are of perishable nature.
ii. When the concern had already purchased huge quantities of raw materials and the prices of
these materials is falling considerably in the market.
iii. When competitors are to be eliminated from the market.
iv. When a new product is to be introduced in the market.
v. To avoid shut-down costs.
vi. To push-up the sale of another highly profitable product.
vii. To capture future market.
viii. To capture foreign market.

8. Curvilinear CVP analysis. (Marks 4)

In CVP analysis, the usual assumption is that the total sales line and variable cost line will have
linear relationship. However, in actual practice it is unlikely to have a linear relationship for two
reasons, namely :
--- After the saturation point of existing demand the sales value may show a downward trend.
--- The average unit variable cost declines initially, reflecting the fact that, as output increases the
firm will be able to obtain bulk discounts on the purchase of raw materials and can also benefit
from division of labour. When the plant is operated at further higher levels of output, due to
bottlenecks and breakdowns the variable costs per unit will tend to increase. Thus the law of
increasing costs may operate and the variable cost per unit may increase after reaching a
particular level of output.
In such cases, the contribution will not increase in linear proportion on the phenomenon of
diminishing marginal productivity, the total cost line will not be straight, as assumed but will be of
curvilinear shape. This situation will give rise to many break even points. The optimum profit is
earned at the point where the distance between sales and total cost is the greatest.

Total ( )

Loss
Total revenue
 28

Profit
A1 and A2 are
break—even
Total cost point

Loss

Quantity

9. Profit graph (Marks 4)

Profit graph is a special type of break–even chart which shows the profit or loss at different levels of
output.

In the following example:

OA = Total fixed expenses C = Break even point
Y
B
Profit

O C D
Loss single product
x
Sales
A
The profit or loss can be calculated by using following when sales are at zero, the total loss is equal
to fixed expenses which is equal to OA. The loss demises as the output reaches C, the break –
even point and the firm starts earning profits as the output increases beyond the break – even point.
The total profit at output level D is equal to DB.

When more than one product is manufactured, the Profit graph can be so drawn as to show the
cumulative effects of the profit and losses.

Y
Profit Line
C
B

O
X
BE Sales value
A

Avg. Profit Line

F
 29
To draw the above diagram , following steps are required --

Step-1: Compute P/V ratio for each product & give rank.

Step-2: Calculate cumulative sales & cumulative profit on the basis of the above ranking.

Step-3: Identify the points on the basis of cumulative sales (x) & cumulative profit (y). Join the
points with same line.

Step-4: Join the start & end point with a single straight line to find average Break even sales

10. Distinguish between “ product cost or marginal cost” and “differential cost” (3 marks)

Answer

Marginal cost represents the increase or decrease in total cost which occurs with a small changes in
output say, a unit of output. In Cost Accounting variable costs represent marginal cost.

Differential cost is the change (increase or decrease) in the total cost (variable as well as fixed) due
to change in the level of activity, technology or production process or method production.

In other words, it can be defined as the cost of one unit of product or service, which would be
avoided if that unit was not produced or provided.

The main point, which distinguishes marginal cost and differential, is that of change in fixed cost
when volume of production increases or decrease by a unit of production. In the case of differential
cost variable as well as fixed cost i.e. both costs change due to change in the level of activity,
whereas under marginal costing only variable cost changes due to change in the level of activity.
11. Discuss the relationship between Angle of Incidence, Break-even Level and Margin of Safety.
(4 marks)
Answer
1. If the break-even point is low and angle of incidence is large. The margin of safety is large and
the business enjoys financial stability. A low break-even point indicates that the business could
be run profitably even if there is a fall in sales, unless the sales are very low.

2. If the break-even point is low and angle of incidence is small, the conclusions are the same as in
1 above except that the rate of profit earning capacity is not so high as in 1.

3. If the break-even point is high and angle of incidence is small. The margin of safety is low. The
business is very vulnerable, even a small reduction in activity may result in a loss.

4. If the break-even point is high and angle of incidence is large. This shows that the margin of
safety is low. The business is likely to incur losses through a small reduction in activity.
However, after the break-even point, the business makes the profit at a high rate.

12. Briefly explain the method of separating semi-variable costs into their fixed and variable elements.
(4 marks)
Answer
Semi-variable costs are partly fixed and partly variable in a linear format. The methods of separating
the semi-variable costs into it’s fixed and variable elements are as under :

(i) Graphical method :

large number of observations of the total costs at different levels of output are plotted on a
graph. Then a line of “best fit”, which passes through all or more of the points is drawn.
 30
The point at which this line cuts the Y-axis indicates the total fixed cost component in the
total cost. The variable cost at nay level of output, is derived by deducting this fixed cost
element from the total cost. The following diagram illustrates this.

Variable cost
For the output

Semi-variable
Costs ‘000 Rs.

Fixed costs

Output ‘000 units

(ii) High points and Low points method :

Under this method, the difference between the total cost at highest and lowest volume is
dividend by the difference between the sales value at the highest and lowest volume. The
result so obtained gives the rate of variable cost in relation to sales value. The fixed cost
is the remainder; i.e. total cost minus total variable cost.

(iii) Comparison by period or level of activity method :

Under this method, the variable cost per unit may be determined by comparing two levels
of output with the amount of expenses at those levels. Since the fixed element does not
changes, therefore the variable element of cost may be ascertained with the help of the
following formula :
Change in the amount of expenses ÷ Change in the quantity of output.

(iv) Least squared method : This is the best method of separating semi-variable costs into their
fixed and variable elements. It is a statistical method and is based on finding out a line of best
fir for a number of observations. The method uses the lower equation y = mx + C ; where m
represents the total cost, ‘x’ represents the volume of output. The total costs is thus split into
fixed and variable elements by solving this equation.

(v) Analytical method : An attempt is made under this method to judge empirically the proportion
of semi-variable cost and fixed cost. The degree of variability is determined for each item of
semi-variable cost. Once this has been done, the method is easy to apply.

13. Explain, how Cost Volume Profit (CVP)-based sensitivity analysis can help managers cope with
uncertainty. (4 marks)

Answer.
Sensitivity analysis focuses on how a result will be changed if the original estimates or the underlying
assumptions change.
 31
Cost Volume Profit (CVP) – based sensitivity analysis can help managers to provide answers to the
following questions to cope with uncertainty.

1. What will be the profit if the sales mix changes from that original predicted ?
2. What will be the profit if fixed costs increase by 10% and variable costs decline by 5%.

The use of spread sheet packages has enable managers to develop CVP computerised models
which can answer the above questions. Managers can now consider alternative plans by keying the
information into a computer, which can quickly show changes both graphically and numerically.

Thus managers can study various combinations of changes in selling prices, fixed costs, variable
costs and product mix, and can react quickly without waiting for normal report from the accountant.
In this manner the use of CVP based sensitivity analysis can help managers to cope up with
uncertainty.

14. Two companies, H and L, have the same values for turnover and net profit and make a similar
product. H has a higher P/V ratio than L. Which company will perform better when: (i) the market
demand is high? (ii) the market demand is low? (2 Marks)

Answer
(i) In case Market Demand is High – Product H (Lower Variable Cost and Higher Fixed Cost)
(ii) In case Market Demand is Low – Product L

15. State the non-costing to be considered in make/buy decision. (4 marks)

Answer
Non –cost in makes / buy decision :

(i) Possible use of release production capacity and facility as a result of buying instead of making.
(ii) Sources of supply should be reliable and they are capable of meeting uninterruptedly the
requirement of the concern.
(iii) Assurance about the quality of goods supplied by outside supplier.
(iv) Reasonable certainly, from the side of supplier about the delivery dates.

(v) The decision of buying the product / component from outside suppliers should be discouraged,
if the technical know-how used is highly secretive.

(vi) The decision of buying from outside sources not result in the laying off o f workers and creates
industrial relation problems. In fact, on buying from outside the resources freed should be better
utilised elsewhere in the concern.

(vii) The decision of manufacturing product/component should not adversely affect the concern’s
relationship with suppliers.

(ix) In case the necessary technical expertise is not available internally then it is better to buy the
requirements from outside.

16. Enumerate the factors involved in decisions relating to expansion of capacity. (3 marks)
Answer
The factors involved in decision relating to expansion of capacity are enumerated as below :
 32
(i) Additional fixed overheads involved should be considered.
(ii) Possible decrease in selling price due to increase production capacity.
(iii) Whether the demand is sufficient to absorb the increase production.

17. State the relative economics of the “makes vs. buy” decision in management control.
Answer
A company generally buy a component instead of making it under following situations :
1. If it costs less top buy rather than to manufacture it internally ;
2. If the return on the necessary investment to be made to manufacture is not attractive enough;
3. IF the company does not have the requisite skilled manpower to make;
4. If the concern feels that manufacturing internally will mean additional labour problem;
5. If adequate managerial manpower is not available to take charge of the extra work of
manufacturing;
6. If the component shows much seasonal demand resulting in a considerable risk of maintaining
inventories. ;
7. If transport and other infrastructure facilities are adequately available;
8. If the process of making is confidential or patented;
9. If there is risk of technological obsolescence for the component such that it does not encourage
capital investment in the component.

18. Differentiate between ‘cost indifference point’ and ‘break-even point’.

Answer
Distinction between Cost indifference point and Break-even point :
Cost indifference point : It is the point at which total cost lines under the two alternatives intersect
each other. Cost indifference point is calculated as Difference in fixed costs ÷ saving in variable cost.
Break-even point : It is the point where the total cost line and total revenue line for a particular
alternative intersect each other. Break-even point calculated as Fixed costs÷ Contribution per unit or
the Fixed costs÷ PV ratio.
The following are the main point of distinction between cost indifference point and break-even point.
(i) The cost indifference point is the activity level at which total cost under two alternatives are
equal. Whereas break-even point is the activity level at which the total revenue form a product
mix is equal to its cost.

(ii) Cost indifference point is used to choose between two alternative processes for achieving the
same objective. The choice depends on the estimated activity level. Break even point is used
for profit planning.

19. What is disinvestment strategy? Highlight the main reasons for disinvestment.

Solution
Divestment involves a strategy of selling off or shedding business operations to divert the resources,
so released, for other purposes. Selling off a business segment or product division is one of the
frequent forms of divestment strategy. It may also include selling off or giving up the control over
subsidiary where by the wholly owned subsidiaries may be floated as independently quoted
companies.

Reason for Divestment Strategy

1. In case of a firm having an opportunity to get more profitable product or segment but have
resource constraint, it may selling off its unprofitable or less profitable division and utilized the
recourse so released. Cost Benefit analysis & Capita Budgeting Method are the useful tool for
analyzing this type of situation.
 33

2. In case of purchase of new business, it may be found that some of the part of the acquired
business is not up to the mark. In such type of situation disposal of the unwanted part of the
business is more desirable than hold it.
3. In case where any business segment or product or subsidiary is pull down the profit of the whole
organization, it is better to cut down of that operation of the product or business segment.

4. In case where any business segment or product or subsidiary is pull down the profit of the whole
organization, it is better to cut down of that operation of the product or business segment.

20. What qualitative factors should be considered in an decision to outsource manufacturing of a

product? (4 Marks)

Answer
The following qualitative factors should be considered in an outsourcing decision:

(i) Whether the vendor will acquire the technology and will emerge as a competitor?
(ii) Whether the vendor will be able to maintain the quality? It the vendor fails to maintain the
quality, will the company loss customers?
(iii) Whether the company will lose its skills in manufacturing the product and if will find difficult to
resume production internally?
(iv) Whether laying off employees will demoralize the work force?
(v) Whether the price quoted by the vendor is a penetrating price? It so, it is likely to increase i.e.
Whether price will increase.

Absorption Costing
(Also known as Volume base costing, Traditional pricing technique or Normal pricing
technique or Printing Pricing technique.)
Traditional absorption costing evolved in the early 1900s. In 1901 the British Federation of Master Printer
set out to find a solution to the cost/ price problem. Twelve years later, in 1913, they issued The Printer’s
Cost Finding System, which was an absorption Costing system.
Steps :
1. Find budgeted overhead according to function of
(a) Production overhead : via allocation, apportion & re-apportion,
(b) Administration- in nature of production ,
(c) Administration-in nature of marketing,
(d) Research & Development,
(e) Quality control &
(f ) Selling and Distribution overhead .
2. Find budget volume or basis of recovery on normal capacity e.g. MHR,LHR, D/Wgs.
3. Find budgeted overhead recovery rate for each department.
 34
4. Apply/Absorb/Charged/Recover/Added the overhead = actual basis x recovery rate.
5. Find the sale price for the job / order. (Apply the format below). Prepare P&L a/c as in ABS costing.
6. Compute the amount of under or over recovery for reconciliation with the actual profit or profit as in
marginal costing.
Job cost sheet of a Product as in Absorption Costing
Messer’s …. ( name of the company)
Cost Sheet for the product……. from …….. To……………. Units produced….

Elements of costs Amount

( )
Direct material Xx
Direct Labour Xx
Direct expenses ( Ref N-8) Xx
Prime Cost Xx
Production or Works or Factory Overheads xx
Administration overhead of Production nature Xx
Research & development cost Xx
Quality control cost Xx
Factory Cost Xx
Add: Opening WIP Xx
Less: Closing WIP Xx
Works Cost Xx
Add: Packing cost Xx
Less: Credit for scrap Xx
Cost of production ( for captive consumption)
Xx
Add: Opening stock of finished goods
Xx
Less: Closing stock of finished goods
Xx
Cost of goods sold
Marketing overheads: Xx
Administration overhead of marketing nature xx
Selling overhead xx
Distribution overhead Xx
Cost of sales xxx
Add: Profit xx
Estimated sales price xxx

Note : This cost statement has been adopted by ICAI ( Ref : Students’ Journal Pg. 7 of July , 2004 )

Note:
1. Direct expenses are the expenses other than direct material cost and direct employees costs which
can be identified with the product. Generally these items are lump sum nature & not a common for
the products. It includes :
i) Cost of utilities such as fuel, power, water, steam, etc.,
ii) Royalty based on production
iii) Technical Assistance / know how fees (related to Project Managers)
iv) Amortized cost of moulds, patterns, patents, etc.
v) Hire charges for tools and equipment
vi) Charges for a particular product designing, etc.,

2. Production / works overhead/ manufacturing Expenses :

i) Consumable stores and spares
ii) Depreciation of plant and machinery, factory building, etc.,
iii) Lease rent of production assets
iv) Repair and maintenance of plant and machinery, factory building, etc.,
 35
v) Indirect employees cost connected with production activities
vi) Drawing and Designing department cost.
vii) Insurance of plant and machinery, factory building, stock of raw materials & WIP, etc.
viii) Amortized cost of jigs, fixtures, tooling, etc.
ix) Service department cost e.g. Tool Room, Engineering & Maintenance, Pollution Control.
x) Salaries for staff for production planning, technical supervision, factory administration etc.,
xi) Normal idle time cost & all normal losses. Abnormal losses are transfer to P&L a/c
xii) Expenses for stores management
xii) Security expenses in the factory
xiii) Labour welfare expenses
xiv) Dispensary and canteen expenses

3. Quality Control Cost

The quality control cost is the expenses incurred relating to quality control activities for adhering to
quality standard.(Ref Chapter Quality Control).

4. Research and Development Cost

the research and development cost incurred for development and improvement of the process or
the existing product shall be included in the cost of production. This cost is distributed on the basis of
Product Life Cycle.

5. Administrative/ office / establishment Overheads

Administrative overheads are to be collected in different costs pools such as :
--- General Office
--- Personnel department
--- Accounts department
--- Legal department
--- Secretarial department .etc.

Administrative overheads are to be further analysed into two-one for production activities and other
for sales and distribution activities. Costs collected under the cost pools indicated above are to be
distributed to administrative overheads relating to production activities and administrative overheads
relating to selling and distribution activities on rational basis for each cost pool.
Administrative overheads relating to production activities are to be apportioned to different
production cost centres on the basis conversion costs of production cost centres. Administrative
overheads relating to selling and distribution activities are to be recovered on basis of sale value or
sale units or production cost.

6. Selling costs are indirect costs related to selling of products or services and include all indirect cost
in sales management for the organization.
 Salaries commission and traveling expenses for sales personnel
 Advertisement cost Legal expenses for debt realization
 Market research cost Royalty on sale
 After sales service cost Rent of the show room
 Travelling expenses Warranty claim
 Brokerage & commission Advertisement relating to sales and sales promotion
 Sales incentive Bad debt (deductible from actual sales), etc.,
7. Distribution Costs are the cost incurred in handling a product from the time it is completed in the
works until it reaches the ultimate consumer.
e.g. Transportation cost, Cost of warehousing salable products, cost of delivering the products to
customers, Secondary Packaging,Freight & Forwarding, Insurance of Warehousing & Storage
8. Additional Notes :
 36
1. Primary packing costs is included in production cost whereas secondary packing cost is
distribution cost. Primary packing is the minimum required packing at the time completion of
production. So it should be added with the complete product although it is a D/exp.
2. In exceptional cases, for example in case of heavy industries equipment supply, installation
cost at delivery site for heavy equipments which involves assembling of parts, testing etc., is
included in production cost but not distribution cost. For example, installation cost of a gas
turbine at plant site is included in the cost of production.
3. Items not included in product cost
 Provision for bad debt & discount & rebate
 Interest on loan unless the loan is taken for a specific machine
 Provision for tax
 Cash & Trade discount
 Any charges of financial nature, etc
9. Distinguish between absorption costing and marginal costing. (Marks 4)

Absorption Costing Marginal Costing

1. It is a total cost technique i.e. both Only variable costs are charged to product,
variable and fixed costs are charged to Fixed costs are charged as period costs to
products, processes or operations. the profit statement .
2. Fixed factory overheads are absorbed The cost of production under this method
by the production units on the basis does not include fixed factory overheads
of a predetermined fixed factory and therefore, the value of closing stock
overhead recovery rate based on comprises of only variable costs. No part of
normal capacity Under/over absorbed the fixed expenses in included in the value
overheads are adjusted before of closing stock and carried over to the next
arriving at the figure of profit for a period.
particular period.

3. Inspire of best possible forecast Since fixed overheads are not included in the
and equitable basis of cost of production, therefore the question of
apportionment/allocation of fixed costs, their under/ over recovery does not arise.
under or over recovery of fixed
overheads generally arises.
4. Managerial decisions under this costing Here decisions are made on the basis of
technique are based on profit i.e. contribution i.e. excess of sales price over
excess of sales value over total costs, variable costs. This basis of decision making
which may at times lead to erroneous Results in optimum profitability.
decisions.
10. “Use of absorption costing method for the valuation of finished goods inventory provides incentive for
over-production.” Elucidate the statement. (Marks 4)

Answer
When absorption costing method is used, production fixed overheads are charged to products and
are included in product costs. Consequently, the closing stocks are valued on total cost (including
fixed overheads) basis. The net effect is that the charge of fixed overheads to P/L accounts gets
reduced, if the closing stock is greater than the opening stock. The situation has the effect to inflating
the profit for the period.

Where stock levels are likely to fluctuate significantly, profits may be distorted if calculated on
absorption costing basis. If marginal costing is used, since the fixed costs are charged off to P/L
account as period cost, such a situation will not arise. The impact of using absorption costing on
profit can be summarized as under.
 37

a. When sales are equal to production, profit will be the same under absorption costing and
marginal costing.

b. If production is higher than sales, then profit in absorption is higher than marginal costing.

c. If sales are in excess of production, absorption will show lower profits than marginal costing.

Since profit calculation in absorption costing can produce strange result, the managers may
deliberately alter the stock levels to influence the profits if absorption costing is used. Hence, it is
true to say that if absorption costing method is used managers have the incentive to over produce to
show better result.

11. “The use of Absorption Costing method in decision-making process leads to anomalies.” Discuss.
(4 marks)
Solution
In absorption costing, fixed overheads are assigned to products by establishing overhead absorption
rates based on budgeted or normal output. By using absorption costing principles, it is possible for
profit to decline when sales volume increases. If the stock levels fluctuate significantly, profits may
be distorted because stock changes will significantly affect the amount of fixed overheads allocated
to a period. If profits are measured on monthly or quarterly or on periodical basis, seasonal
variations, in sales may causes significant fluctuations in profits.

Internal profit statements on monthly or quarterly basis are used for measuring the managerial
performance. In the circumstances, managers may deliberately alter inventory levels to influence
profit, if absorption costing is used. When sales are less and the closing inventory increases, a part
of the fixed overheads contained in the value of the closing stock is reduced from the fixed costs
allocated to production for the period. Thus, if sales are reduced, inventories will increase and
absorption cost will past higher profits. Similarly, if sales are increased as compared to production,
inventories will be reduced and absorption costing will return lower profits.

Standard Costing
1. CIMA’s terminology defines Standard Costing as follows:
It is a control technique which compares standard costs and revenues with actual results to obtain
variances which are used to stimulate improved performance.
There is very close relationships between standard costing and budgetary control. Both of them
compare the actual results with the expected performance to identify any variances. The difference is
that, with standard costing the comparison is usually made at a unit level, that is, the actual cost is
compared with the standard cost per unit on actual volume, budgetary control works on total cost
basis. Another difference is that, in presence of Standard Costing, a budget is multiplication of
Standard cost p.u. with budgeted output.

2. Standard & Standard Cost: (4 marks)

 38
Standard is defined as a benchmark measurement of resource usage, set in defined conditions. The
definition goes on to describe a number of bases which can be used to set the standard, including:
 A prior period level of performance by the same organization;
 The level of performance achieved by comparable organizations;
 The level of performance required to meet organizational objectives.
Use of the first basis indicates that management feels that performance levels in a prior period have
been acceptable. They will then use this performance level as a target and control level for the
forthcoming period.
When using the second basis management is being more outward looking, perhaps attempting to
monitor their organization’s performance against ‘the best of the rest’.
The third basis sets a performance level which will be sufficient to achieve the objectives which the
organization has set for itself.
A Standard cost is a carefully predetermined unit cost which is prepared for each cost unit. It
contains details of the Standard amount and price of each resource that will be utilised in providing
the service or manufacturing the product.

3. Budgetary control (2 marks)

It is defined as
a. the establishment of budgets relating the responsibilities of executives to the requirements of a
policy and
b. the continuous comparison of actual with budgeted results, either to secure by individual action
the objective of that policy or to provide a basis for its revision.

4. Limitations of Budgetary Control System: (3 marks)

1. Budgets are considered as rigid document.
2. Budgets cannot be executed automatically
3. Staff co–operation is usually not available during budgetary control exercise.
4. Its implementation is quite expensive.

5. Types of Standard: (4 marks)

A. Ideal Standard:
Standards may be set at ideal levels, which make no allowance for normal losses, waste and
machine downtime. This type of ideal standard can be used if managers wish to highlight and
monitor the full cost of factors such as waste, etc., however, this type of standard will almost always
result in adverse variances since a certain amount of waste, etc., is usually unavoidable. This can be
very de-motivating for individuals who feel that an adverse variance suggests that have performed
badly.
B. Attainable Standard:
Standards may also be set at attainable levels which assume efficient levels of operation, but which
include allowances for factors such as normal loss, waste and machine downtime. This type of
Standard does not have the negative motivational impact that can arise with an ideal standard
because it makes some allowance for unavoidable inefficiencies. Adverse variances will reveal
whether inefficiencies have exceeded this unavoidable amount.

C. Basic Standard:
A basic standard is one which is kept unchanged over a period of time. It is used as the basis for
preparing more up-to-date standards for control purposes. A basic standard may be used to show
the trend in costs over a period of time.

6. Setting Standard costs: (4 marks for each parts)

A. Standard material price:

 39

a) Quotations and estimates received from potential suppliers.

b) Trend information obtained from past data on material prices.
c) Details of any bulk discounts which may be available.
d) Information on any charges which will be made for packaging and carriage inwards.
e) The quality of material to be used: this may affect the price to be paid.
f) For internally manufactured components: the predetermined standard cost for the component will
be used as the standard price.

B. Standard material usage:

a) The basis to be used for the level of performance.

b) If an attainable standard is to be used, the allowance to be made for losses, wastage, etc. Work
study techniques may be used to determine this.
c) Technical specifications of the material to be used.

C. Standard labour rate:

a) The personnel department for the wage rates for employees of the required grades with the
required skills.
b) Forecasts of the likely outcome of any trades union negotiations currently in progress.
c) Details of any bonus schemes in operations.

D. Standard labour times:

a) The basis to be used for the level of performance.

b) If an attainable standard is to be used, the allowance to be made for downtime, etc.
c) Technical specifications of the tasks required to manufacture the product or provide the service.
d) The results of work study exercises which are set up to determine the standard time to perform
the required tasks and the grades of labour to be employed.

E. Production overhead costs:

Overhead absorption rates, represents the standard hourly rates for overhead in each cost centre.
They can be applied to the standard labour hours or machine hours for each cost unit. The
overheads will usually be analysed into their fixed and variable components so that a separate rate is
available for fixed production overhead and for variable production overhead.

7. Briefly explain the cost ledger accounting system and the integrated accounting system. What
advantages do you expect in an integrated system ? (4 marks)

Answer
Cost accounts can be maintained in the following two ways :
(i) Cost Ledger accounting system.
(ii) Integrated Accounting system.

Cost Ledger Accounting System : Under this system, separate set of books are maintained for
costing and financial data. In this system, cost ledger is the principal book of accounts. It is also
known as non-integral accounting system where finished goods ledger, Wages ledger and Overhead
ledger are also maintained.

Integrated Accounting System : Under this method, costing and financial records are kept in the
same set of books to give all information that may be required either for financial or for costing
 40
purposes. Entries are made in such a way as to enable one to ascertain the cost of each activity
continuously.

Advantages of Integrated Accounting System :

1. Economical and high speed.
2. Eliminates duplication of work.
3. Help to avoid reconciliation of finance & cost accounts.
4. Cost data are obtained without any delay.
5. The system provides an automatic check on the correctness of data.

8. List four major uses of standard costs. (4 marks)

Answer
The four major uses of standard costs are as follows:-
(1) Effective way of planning and controlling costs.
(2) Pricing decisions involving submission of quotations, answering tenders etc. are facilitated.
(3) Identifying variances with a view to improve performance or to correct loose standards.
(4) Facilitates management by expectation.

9. Which accounting plan of standard costing helps to convert standards into Actuals by using the
rations? (1marks)

Answer : Dual plan.

10. Suggest the problems concerning control of operations that a manufacturing company can be
expected to experience in using a standard costing system during periods of rapid inflation.(4 marks)

Answer
(i) The formulation/setting of material standards makes assumptions about the inflation, which will
prevail in future. If this assumption is not stated clearly then it is difficult to determine how
much of price variance is due to inflation and how much is due to buying efficiency.

(ii) Price indices tend to reflect average price changes. Consequently, it is difficult for a company
to predict future costs and interpret variances if the specific rate of inflation for its inputs is
considerably different fro, the general rate of inflation.

(iii) Inflation may result in relative changes in the prices of inputs. Therefore, standard mixes
requiring different inputs may no longer be the most efficient mix.

(iv) If standard prices are not adjusted then the efficiency variances will be understated.

(v) Sharp rises in prices will raise questions as to whether unadjusted standards can be used in
the decision making process (e.g. Pricing decisions).

(vi) Administrative work involved in maintaining upto – date standards when prices are constantly
changing will increase.

11. What are the basic differences between Standard Costing and Budgetary Control? (7Marks)

Answer
Basic differences between Standard Costing and Budgetary control are as follows :

i. Standard costs are ascertained for material labour and overhead. Here the control of each
element of cost is effected by comparing actual costs with standard costs of actual output.
 41
Whereas budgets are prepared for different functions like sales, production, capital assets etc. of
business. Budgetary control here is concerned with the overall profitability and financial position
of the business.

ii. Range of standard costing is narrow as it is mainly confined to the control of production costs.
But the range of budgeting is wider than that of standard costing. It in fact cover sales, capital
and financial expenses as well.

iii. Standard costing is confined to the projection of cost accounts only whereas budgetary control
includes projection of financial accounts as well.

iv. For exercising control, variances are computed in standard costing as well as budgetary control.
But these variances are normally recorded in different cost accounts under standard costing
whereas they are not revealed under budgets.

v. Under standard various causes of variances in respect of each cost element can be analysed in
minute detail and corrective action taken accordingly.
Whereas budgetary control system deals with total expenses and revenues based on estimates.

12. How are cost variances disposed off in a standard costing system? Explain (3 marks)

Answer
There is no unanimity of opinion among Cost Accountants regarding the disposition of variances.
The following are commonly used methods for their disposition.

1. Transfer all variances to Profit and Loss Account

2. Distributing variances on pro-rata basis over the cost of sales, work-in-progress and finished
goods stocks by using suitable basis.

3. Write off quantity variances to profit and loss account and spread price variance over to cost of
sales, work-in-progress and finished goods.

13. Calculation of variances in standard costing is not an end in itself, but a means to an end” Discuss.
(4 marks)
Answer

The variance is the difference between the actual performance and the standard performance. The
calculations of variances are simple. A detailed computation of variances helps the management to
ascertain :

(i) the amount of a variance

(ii) the factors or causes of their occurrence
(iii) the responsibility to be laid on executives and departments and
(iv) corrective actions which should be taken to obviate or reduce the variances.

Mere calculation and analysis of variances is of no use. The success of variance analysis depends
upon quickly and effectively the corrective actions can be taken. The manager needs to corrective
action quickly on the information provided by the variances. Information is the means and action
taken on it is the end. In other words, the calculation of variances in standard costing is not an end
in itself, but a means to an end.
 42
14. Discuss three distinct group of variances that arise in standard costing. (6 Marks)

Answer

The three distinct groups of variances that arise in standard costing are :

(i) Variances of efficiency : These are the variances, which arise due to efficiency or inefficiency
in use of materials, labour etc.

(ii) Variances of prices and rates : These are the variances, which arise due to changes in
procurement price and standard price.

(iii) Variances due to volume : These represent, the effect of difference between actual activity
and standard level of activity.

These can be summarized as under :

Element of cost Variance of Variance of Variance of

Efficiency price volume

Materials Usage, Mixture Yield Price Revision

Labour Efficiency, Idle time Rate of Pay ---
Overheads
-- Variable Efficiency Expenditure Revision
-- Fixed Efficiency Expenditure Revision,
Capacity

Calendar

15. State the features of Partial Plan of Standard Cost Accounting procedure . (4 marks)

Answer

Standard cost operations can be recorded in the books of account by using partial plan. Features of
partial plan of standard costing procedure are as follows :
(i) Partial plan system uses current standards in which the inventory will be valued at current
standard cost figure.
(ii) Under this method WIP account is charged at the actual cost of production for the month and is
credited with the standard cost of the month’s production of finished product.
(iii) the closing balance of WIP is also shown at standard cost. The balance after making the credit
entries represent the variance from standard for the month.

(iv) The analysis of variance is done after the end of the month.
 43

16. “Standard costing system is not compatible with Activity Based Costing System.” Do you agree with
this statement? Explain your answer. (4 marks)

Answer
Standard costing system is a tool for cost control. Traditionally, standards are established for each
element based on engineering specifications. Variances between standard costs and actual costs
are reported periodically to managers. Managers use the information for remedial measures or for
revision of standards.

In ‘Activity Based Costing System’ costs are collected around activity pools and are assigned to
products and services using appropriate cost drivers. Standards can be established for costs for
carrying out each type of activity. Therefore, it is not correct to say that the standard costing system
is not compatible with Activity Based Costing System.

17. Under the single plan, record the journal entries giving appropriate narration, with indication of
amounts of debits or credits alongside the entries, for the following transactions using the respective
control A/c.
(i) Material price variance (on purchase of materials)
(ii) Material usage variance (on consumption)
(iii) Labour rate variance. (2 marks each)

Solution
i) Dr. Material Control A/c
Dr. or Cr. Material Price Variance A/c
Cr. Creditors A/c
(Being price variance during purchase of materials)

ii) Dr. WIP Control A/c

Dr. or Cr. Material Usage Variance A/c
Cr. Material Control A/c
(Being recording of usage variance at standard cost of excess/under utilized quantity)

iii) Dr. Wages Control A/c

Dr. or Cr. Labour Rate Variance A/c
Cr. Cash
(Being entry to record wages at standard rate)

The Balanced Scorecard:

An approach to the provision of information to management to assist strategic policy formulation and
achievement. It emphasises the need to provide the user with a set of information which addresses
all relevant areas of performance in an objective and unbiased fashion.

The contents of a balanced scorecard will vary from business to business, but most include the
following measures; profitability – the ‘financial perspective’; customer satisfaction – the ‘customer
perspective’; innovation – the ‘innovation and learning perspective’; and internal efficiency – the
‘internal business perspective’.

It helps top management to evaluate whether lower–level managers have improved one area at the
expense or others. For example, a manager at risk of not meeting operating profit goals may start to
ship high-margin products and delay deliveries of low-margin products. The balanced scorecard will
 44
recognize the improvement in financial performance but will also reveal that operating profit targets
were achieved by sacrificing on-time performance.

How do we look to shareholders

Share Holders
Financial perspectives
Goals Measures

Internal business
Vision perspective pr
Customer Perspective an
Goals Measures d Goals Measures
str

Innovation &
learning
Goals Measures

Four perspectives are typically integrated in a balanced scorecard :

1. Customer perspective: It requires customers themselves to identify a set of goals and measures on
factors which really matter to them. Performance measures such as time, cost, quality, performance
and service should be developed by groups of managers working with customers to understand their
primary requirements.

Goals Measures
New products % of sales from new products
% of sales from proprietary products.
Responsive supply On-time delivery (defined by customers)
Preferred supplier Share of key accounts’ purchase
Customer partnership Ranking by key accounts
No. of co-operative engineering efforts.

2. Internal perspective: The organisation must excel at certain internal processes, decisions and
actions if it is to meet these customer requirements. The internal perspective must reflect the
organization’s core skills and the critical technology involved in adding value to the customer’s
business.

Internal business perspective

Goals Measures
Technological Capability Manufacturing geometry v. competition
Manufacturing excellence Cycle time & Unit cost & Yield
Design productivity Engg. Efficiency.
New prod. Introduction Actual introduction schedule v. plan.
 45
3. Innovation & learning: The innovation and learning perspective is required in order to recognize
that this is constantly seek to learn, to innovate and to improve every aspect of the organisation
and its business just to maintain their competitive situation, let alone to improve in the future.
Innovation & learning perspective
Goals Measures
Technology leadership Time to develop next generation
Manufacturing learning Process time to maturity
Product focus % of products that equal 80% of sales
Time to market New product introduction v. competition.

4. Financial perspective: The financial perspective covers traditional measures such as growth,
profitability and shareholder value but are set through talking to the shareholders(s) direct.

Goals Measures
Survive Cash flow
Succeed Quarterly sales growth & operating income
Prosper Increased market share & return on equity

1. Classify the following measures under appropriate categories in a balanced score card for a banking
company which excels in its home loan products:
(i) A new product related to life insurance is being considered for a tie up with the successful
housing loan disbursements, e.g. every housing loan applicant to be advised to take a life
policy or compelled to take a fire insurance policy.
(ii) How different sectors of housing loans with different interest rates have been sanctioned,
their volumes of growth in the past 4 quarters.
(iii) How many days are taken to service a loan, how many loans have taken longer, what
additional loans are to be released soon, e.t.c ( 1 mark each)
Answer
(i) New product tie up - Innovation/learning perspective
(ii) Growth of Volume - Financial perspective
(iii) Time for loan/Fresh products - Customer perspective

2. “Hard Rock Coconut” is an exclusive resort located in a famous Island of Pacific Ocean that vows to
isolate its guests from the hustle and bustle of everyday life. Its leading principle is “all contemporary
amenity wrapped in old-world charisma”. Each of the resort’s 18 villas has a separate theme like
Castle, Majestic, Ambassador, Royal Chateau, Coconut, Lemon, Balinese etc and guests often ask
for a specific villa when they make reservations. Villas are Ideal for families or friends travelling
together and these villas feature luxurious accommodation spanning two floors. Since it is located
within a 300-acre estate on white sand beach, the resort offers its guests a wide variety of outdoor
activities such as horseback riding, hiking, diving, snorkelling, sailing, golf and so on. Guests could
also while away the day relaxing in the pool and availing themselves of the resort’s world-famous spa
“Hard Coco Spa”. The dining room, which only has three tables for the public, is acceptable proud of
its 4-star rating.

You are required to develop a balanced scorecard for “Hard Rock Coconut”. It is sufficient to give two
measures in each of the four perspectives. (4 Marks)
 46
Answer
The following is a possible scorecard for “Hard Rock Coconut”

Financial Perspective Economic Value Added

Revenue per villa
Customer Perspective % repeat customers
Number of customer complaints
Internal Business Service rating of spa
Staff hours per guest
% cost spent for maintenance
Travel guide rank for restaurant
Innovation and Learning Employee retention
Number of new services offered

3. “In many organizations, initiatives to introduce balanced score card failed because efforts
were made to negotiate targets rather than to build consensus.”

Required: Elucidate the above statement. (Marks 4)

Solution
Balanced score card is a set of financial and non-financial measures relating to a company’s critical
success factors. It is an approach which provides information to management to assist in strategy
implementation.

Therefore, the components to be included in the balanced score card must flow from strategy. The
targets should be measurable and corporate plan of the company. It is necessary that managers
should agree to the components and targets because in absence of a consensus, managers may not
commit to the targets established by the top management / the board of directors. Moreover, the
functions are interdependent and results in one functional area/perspective (e.g. innovation and
learning) have direct bearing on the results in other functional area / perspective (e.g. customer
perspective). Therefore, it is not sufficient that individual managers agree to their targets. Successful
implementation requires that the top management builds an overall consensus on the components
and targets of the balanced score card. Negotiation undermines the fundamental principle that the
components and targets should flow from strategy. As a result, an approach to establish targets
through negotiation defeats the very purpose of balanced score card.

4. State the main types of information which will be required by a manager to implement the balanced
score card approach to performance measurement. (4 marks)

Answer

The main types of information required by the managers to implement the balanced score card
approach to performance measurement are:

(i) Customer perspective – How do customer see us?

(ii) Internal business process perspective – Where we must excel at?
(iii) Learning and growth perspective - Can we continue to improve and create value?
(iV) Financial perspective – How do we look to the shareholders?
 47
5. Identify Balance Scorecard Perspectives from the following potential measures observed in different
business sectors.

(i) Weekly Patient Complaints

(ii) Patient Satisfaction Survey
(iii) Flight Cancellation Rate
(iv) On-time Performance of an Airline
(v) Number of Grants Awarded to a Healthcare unit
(vi) Outstanding Loan Balances / Deposit Balances of a Banking Company
(vii) Employee Turnover Rate of a Healthcare unit
(viii) Patient Referral Rate
(ix) Non-interest Income of a Banking Company
(x) Lost of Bag Reports per 5,000 Passengers

Answer:
Statement Showing Balance Scorecard Perspectives for Different Business Sectors

Health Care Airlines Banking

Weekly Patient Complaints Internal Operating --- ---
Efficiency
Patient Satisfaction Survey Customer Service --- ---
& Satisfaction
Flight Cancellation Rate --- Customer Service ---
& Satisfaction
On-time Performance of an Airline --- Internal Operating ---
Efficiency
Number of Grants Awarded to a Learning and --- ---
Healthcare unit Growth
Outstanding Loan Balance / Deposit --- --- Financial
Balances of a Banking Company Strength
Employee Turnover Rate of a Learning and --- ---
Healthcare unit Growth
Patient Referral Rate Customer Service --- ---
& Satisfaction
Non-interest Income of a Banking --- --- Financial
Company Strength
Lost of Bag Reports per 5,000 --- Customer Service ---
Passengers & Satisfaction

Benchmarking :
Benchmarking is the continuous process of measuring products, services or activities against the best level
of performance that may be found either inside or outside the organisation. It is a process of comparing a
firm’s activities with best practices.

The process involves establishment of benchmarks (targets or comparators) through whose use the levels
of performance of the company is sought to be improved. Benchmarking is a tool for continuous
improvement because after identifying a best practice performance, it becomes a target to beat.
The steps in Benchmarking or Process of Benchmarking:

1. Planning:
(i) Determination of benchmarking goal statement:
(ii) Identification of best performance.
 48
(iii) Establishment of the benchmarking or process improvement team
(iv) Defining the relevant benchmarking measuremen

2. Pre-requisites of Bench marking:

(i) The objectives of bench marking should be clearly defined.
(ii) Senior Managers should support bench marking and commit themselves for continuous
improvement.
(iii) The scope of the work should be appropriate in the light of the objectives, resources, time
and experience of those involved.
(iv) Sufficient resources should be made available to complete projects within the required time.
(iv) Bench marking teams should have the right skill and competencies.
(v) Stake holders, staff and others should be kept informed of the reasons of bench making

3. Collection of data and information:

The data gathering for benchmarking could be done through national/international clearing houses,
mail surveys, suppliers, company visits, telephone, interviews etc. In recent years national and
international clearing houses have been set up.

4. Analyzing the findings:

(i) Review the findings and produce tables, charts and graphs to support the alysts.
(ii) Identify gaps in performance between our organization and better performers.
(iii) Seek explanations for the gaps in performance. The performance gaps can be positive,
negative or zero.
(iv) Ensure that comparisons are meaningful and credible.
(v) Communicate the findings to those who are affected.
(vi) Identify realistic opportunities for improvements.

5. Recommendations:
(i) Deciding the feasibility of making the improvements in the light of the conditions that apply
within own organization.
(ii) Agreement of the improvements that are likely to be feasible.
(iii) Producing a report on the Benchmarking in which the recommendations are included.
(iv) Obtaining the support of key stakeholder groups for making the changes needed.
(v) Developing action plan(s) for implementation.

6. Monitoring and reviewing:

(i) Evaluating the benchmarking process undertaken and the results of the improvements
against objectives and success criteria plus overall efficiency and effectiveness.
(ii) Documenting the lessons learnt and make them available to others.
(iii) Periodically re-considering the benchmarks

7. Types of Benchmarking
(i) Competitive benchmarking: (ii) Strategic benchmarking:
(iii) Global benchmarking: (iv) Process benchmarking:
(v) Functional Benchmarking or Generic Benchmarking:
(vi) Internal Benchmarking: (vii) External Benchmarking:

8. Suggested code of conduct of benchmarking :

1.Principle of legality2. Principle of exchange
3.Principle of confidentiality 4.Principle of use
5.Principle of first party contact 6.Principle of third party contact
7.Principle of preparation

9. Classify the following measures under appropriate categories in a balanced score card for a banking
company which excels in its home loan products:
 49

(i) A new product related to life insurance is being considered for a tie up with the successful
housing loan disbursements.
e.g. every housing loan applicant to be advised to take a life policy or compelled to take a fire
insurance policy.

(ii) How different sectors of housing loans with different interest rates have been sanctioned,
their volumes of growth in the past 4 quarters.

(iii) How many days are taken to service a loan, how many loans have taken longer, what
additional loans are to be released soon, e.t.c
(Students are not required to copy these statements into their answer books) (3 Marks)

Answer
(i) New product tie up - Innovation/learning perspective
(ii) Growth of Volume - Financial perspective
(iii) Time for loan/Fresh products - Customer perspective

10. Name any four stages in the process of bench marking.

Answer
Various stages in the process of benchmarking.
I Planning - Determination of benchmarking goal statement
- Identification of best performance
- Establishment of the benchmarking or process improvement team
- Defining the relevant benchmarking measures
II Collection of data and information
III Analysis of finding based on data collected
IV Formulation and implementation of recommendation
V Constant Monitoring and reviewing.

11. Explain briefly stages involved in the process of Bench marking.

Solution:
The process of benchmarking requires a Company to identity the areas i.e. processes, activity etc.
which are central to its business and them selects the top-performing companies in those areas.
The benchmarking process is comprised of following stages. These stages are:
(i) Planning:
(a) Determination of benchmarking goal statement: This required identification of areas to be
benchmarked. In practice, one should start with the identification of those areas which have
to be really good to be really successful.
(b) Identification of best performance: Once the benchmarked goal statement are defined, the
step is seeking the best of the breed of best of the best.
 50
(c) Establishment of the benchmarking or process improvement team: Ideally this should include
the persons who are most knowledgeable about the internal operations and will be directly
affected by changes due to benchmarking.
(d) Defining the relevant benchmarking measurement: Relevant measures will not include the
measures used by the organisation today but they will be refined measures that comprehend
the true performance differences.
(ii) Collection of data and information:
The data gathering for benchmarking could be done through national / international clearing houses,
mail surveys, suppliers, company visits, telephone, interviews etc. In recent years national and
international clearing houses have been set up.

(iii) Analysing the findings:

The analysing of finding of step (2) requires following:
(a) Review the findings and produce tables, charts and graphs to support the analysts.
(b) Identify gaps in performance between our organisation and better performers.
(c) Seek explanations for the gaps in performance. The performance gaps can be positive,
negative or zero.
(d) Ensure that comparisons are meaningful and credible.
(e) Communicate the findings to those who are affected.
(f) Identify realistic opportunities for improvements.

(iv) Formulation or Recommendations:

This requires:
(a) Deciding the feasibility of making the improvements in the light of the conditions that apply
within own organisation.
(b) Agreement of the improvements that are likely to be feasible.
(c) Producing a report on the Benchmarking in which the recommendations are included.
(d) Obtaining the support of key stakeholder groups for making the changes needed.
(e) Developing action plan(s) for implementation.

(v) Monitoring and reviewing:

This involves:
(a) Evaluating the benchmarking process undertaken and the results of the improvements
against objectives and success criteria plus overall efficiency and effectiveness.
(b) Documenting the lessons learnt and make them available to others.
(c) Periodically re-considering the benchmarks.
Activity Base Costing:
1. What is activity based costing ? (4 marks)
Answer
Activity based costing : It focuses on activities as the fundamental cost objects and uses the
costs of these activities as building blocks for compiling the costs of other objects.
According to CIMA, It is defined as “Cost attribution to cost units on the basis of benefits received
from indirect activities i.e. ordering, setting-up, assuring quality etc.”
Under activity based costing are accumulated for each activity as a separate cost object. The
collected costs are applied to products based on the benefits received from various activities. The
final product cost are built up from the costs of the specific activities cost pools and in the second
stage cost driver based rates are derived to charge cost to product lines. The cost driver based rates
are based on activities.
 51
Activity based costing can be used for :
(a) Pricing of product ;
(b) Design and development of new products

1. The emergence of ABC systems:

During the 1950s the limitations of traditional product costing systems began to be widely publicised.
These systems were designed decades ago when most companies manufactured a narrow range of
products, and direct labour and materials were the dominant factory costs. Goetz (1949) advocated
ABC principles first.

- Traditional product costing systems were designed when most companies manufactured a
narrow range of products.
- Direct materials and direct labour were the dominant cost factors of production. Then their ratio
with overhead was 100:20.
- Companies were in sellers’ market.
- Overheads were relatively small & distortions due to inappropriate treatment were not significant.
- Cost of processing information was high.
Today companies produce a wide range of products. Overheads are considerable importance.
- Simple methods of apportioning overheads on direct labour or machine hour basis are not
justified as dir cost : overhead is 100: 800.
- Intense global competition calls for correct costing of products to avoid errors in decision making.
i.e. apply the cause & effect relationship.
- Traditional systems can measure volume related costs.
- Non volume related activities like material handling, set up etc. are important and their costs
cannot be apportioned on volume basis.
2. Steps to be followed in ABC
Step 1: Identify the chosen Cost Objects ( product, service or customer )
Step 2: Identify the Direct Costs i.e. Prime cost of the Products, service or customer
Step 3: Select the Activity Bases or Cost Driver .
Step 4: Identify the costs associated with each Activity i.e. cost pool. Apply allocation & apportion
concept of overhead
Step 5: Compute the Rate per cost driver.
Step 6: Compute the Indirect Costs of the selected cost object
= activity for the product  rate per driver.
Step 7: Compute the Total Costs of the cost object = Direct costs + Indirect Costs.
3. State with a brief reason whether you would recommend an activity based system of costing in each
of the following independent situation:

(i) Company K produces one product. The overhead costs mainly consist of depreciation.
(ii) Company L produces 5 different product using different production facilities.
(iii) A consultancy firm consisting of lawyers, accountants and computer engineers provides
management consultancy services to clients.
(iv) Company S produces two different labour intensive products. The contribution per unit in both
products is very high. The BEP is very low. All the work is carried on efficiently to meet the
target costs.

Answer:

SI. Description Recommend Reason

No ABC Yes/No
 52
K produces one product. No One product situation. For allocation of
Overhead is mainly overhead, ABC is not required.
depreciation
ABC for cost reduction not beneficial since
most of the overhead is
depreciation.

L produces 5 different Yes Multi product situation. ABC is required for

products with different allocation of overhead.
facilities. ABC is necessary for pricing.
Cost drivers are likely to be different.
Cost reduction may be possible.
Production facilities are different.

Professional services – Yes Variety of services. Hence ABC is

lawyers/accountants/comput required for cost allocation.
er engineers Services are very different.
ABC is necessary for pricing.
Cost reduction possible.

S produces 2 different labour No Different products, but labour

intensive products. High unit intensive. Hence, overhead
contribution and efficient allocation based on readily traceable
operations. direct labour cost will be accurate.
Hence, ABC not required for cost
allocation.

Low BEP level implies low level of

fixed cost as a % of sale price or as
a % of total cost.

Many fixed cost activity drivers are

likely to align with the direct labour
cost. Hence not required for cost
allocation.

Efficient operation. Hence ABC not

required even for cost reduction or
ABC management.

4. Benefits :
ABC is more expensive than the traditional system. So a cost-benefit analysis is desirable. The
benefits of ABC are many.
1. In ABC managers focus attention on activities rather than products because activities in various
departments may be combined and costs of similar activities ascertained e.g. quality control,
handling of materials, repairs to machines, etc
2. Costs are identified with activities and then allocated to products or services, based on
appropriate cost drivers. So more accurate product/service costs are obtained Since overhead
or indirect costs occupies a significant proportion of the total costs of the firm, the overall impact
of allocation of indirect costs to products/ services more accurately is significant.

3. Managers manage activities and not products. Change in activities lead to changes in costs.
Therefore, if the activities are managed well, costs will fall and resulting products will be more
competitive.
 53
4. To manage activities better, managers need to identify the relationships of activities & costs in a
more detailed & accurate manner.

5. ABC highlights problem areas that deserve management’s attention and more detailed analysis.

5. The main advantages of using Activity Based Costing are:

(i) More accurate costing of products/services, customers, SKUs, distribution channels.
(ii) Better understanding overhead.
(iii) Utilizes unit cost rather than just total cost.
(iv) Integrates well with Six Sigma and other continuous improvement programs.
(v) Makes visible waste and non-value added.
(vi) Supports performance management and scorecards.
(vii) Enables costing of processes, supply chains, and value streams.
(viii) Activity Based Costing mirrors way work is done.
(ix) Facilitates benchmarking.

6. Some important activities & cost driver :

Activity (items) Cost Driver

Machine set-up for production Number of set up / set up hrs
Number of production runs
Purchase materials Number of orders placed
Number of components
Warehousing Items in stock/ wt. / volume

Material handling Number of moves or parts

Number of material moves
Inspection Inspection per item

Quality testing Hours of test time

Receiving material Number of receiving orders

Packing Number of packing orders

Store delivery Number of store deliveries

Research & Development Number of research projects

Personal hours on a project
Technical complexities of projects.
Customer Service Number of service calls.
Hours spent on servicing product
Engineering Production order
Designing cost No. of New job or production order
7. Weakness of ABC

1. ABC fails to encourage managers to think about changing work processes to make
business more competitive. So it does not help in cost reduction.
2. ABC does not conform to generally accepted accounting principles.
3. Using ABC for short-run decisions may sometimes prove costly .
4. ABC does not encourage the identification and removal of constraints creating delays
and excesses.
 54
8. Activity Based Management (ABM)

Activity Based Management (ABM) is a further development on activity based costing (ABC). ABC
refers to cost attribution to cost units on the basis of benefit received from indirect activities e.g.
material ordering, material handling, machine setups, quality assuring, customer support services
etc. For each such activity, it is necessary to identify a cost driver that causes incurrence of cost
relating to that activity. For example, hours spent on testing for a quality assurance activity may be
used as application base of cost driver for this activity.

ABM analyses and manages cost drivers to manage costs. In that process ABM also analyses value
added and non- value added activities in order to eliminate non-value added activities and simplify or
improve upon value added activities. ABM involves:

1. Identification of the major activity areas.

2. Determination of the cost driver for each activity that is used as cost application base.
3. Creation of cost pools for collection of activity costs having the same cost driver.
4. Cost drivers link activities & resources consumption to generate less arbitrary costs for decision-
making.

9. Activity Based Budgeting (ABB)

Activity-based budgeting is a process of planning and controlling the expected activities for
the organisation to derive a cost-effective budget that meets forecast workload and agreed
strategic goals. An activity-based budget is a quantitative expression of the expected
activities of the firm, reflecting management’s forecast of workload and financial and non-
financial requirements to meet agreed strategic goals & planned changes to improve
performance.

Thus, the key elements of ABB are:

 type of work/activity to be performed;
 quantity of work/activity to be performed; and
 cost of work/activity to be performed.

ABB focuses on the activity/business processes. Resources required are determined on the
expected activities and workload. The objective is to bring in efficiency into the system. So,
in the process of budget preparation, many key questions, need to be addressed and
properly answered.

10. ABC based cost hierarchy or four different categories of activities that drive the expenses at the
product level
Level 1 : Unit basis Costs Level 2: Batch basis Costs Level 3: Process level Costs

Level 4 : Product level Costs Level 5 Facility level Costs

A brief explanation of the above activities is given as under :--
(i) Unit level activities ---- (i) Use of indirect materials
(ii) Inspection or testing of every item produced
(iii) Indirect Consumables
(ii) Batch level activities ---- (i) Material ordering
(ii) Machine set up costs
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(iii) Inspection of productslike first item of every batch
(iii) Product Level ---- (i) Designing the product
(ii) Production parts to a certain specification
(iii) Advertising costs, if advertisement is for individual
products
(iv) Facility Level ---- (i) Maintenance of buildings
(ii) Plant security

11. In the context of Activity Based Costing System, explain the following statement: “Strategic
cost analysis should exploit internal linkages”

Answer
Activity based costing is an accounting methodology that assigns cost to activities rather than to
products or services. Activity based Costing tracks the flow of activities by creating internal link
between activity/resource consumption and cost object. Exploiting internal linkages means taking
advantage of the relationships among the activities that exist within a firm’s segment of value chain.
Activity cost and analysis are essential parts of this strategic analysis. Activities not based on
production units/sales units, based on the variable activity drivers are analyzed. The traditional
costing system is not rich enough to supply the information needed for thorough analysis of linkages.

12. Customer driven costs: Supply and delivery patterns; Customer location; Quality provided;
Provision of after sales service; Sales and promotion effort, Discounts given.

13. Explain the concept of cost drives.

Indicate what you will consider as cost drives for the following business functions:
(i) research and development; and
(ii) customer service (4 marks)

Answer.
A cost driver is any factor whose change causes a change in the total cost of a related cost object.
In other words, a change in the level of cost driver will cause a change in the level of the total cost of
a related cost object.
The cost drives for business function viz., Research & Development and Customer Service are as
below :
Business functions:
Cost drives
Research & Development - Number of research projects
- Personal hours on a project
- Technical complexities of projects.
Customer Service - Number of service calls.
- Hours spent on servicing product
14. What are the areas in which Activity based Information is used for decision making ? (4 marks)

Answer.
The areas in which Activity based Information is used for decision making are as under :

(i) Pricing
(ii) Market segmentation and distribution channels
(iii) Make-or-buy decisions and outstanding
(iv) Transfer pricing
(v) Plant closed down decisions
(vi) Evaluation of offshore production
(vii) Capital Investment decisions
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(viii) Product line profitability

15. Explain which features of the Service organisations may create problems for the application of
activity – based costing. (Marks 4)

Answer
The following may create problem for adoption of ABC system in service organization -
(i) Facility sustaining costs (such as property, rents etc.) represent a significant portion of total
costs and may only be avoidable if the organization ceases business. It may be impossible to
establish appropriate cost drivers.

(ii) It is often difficult to define products where they are of intangible nature. Cost objects can
therefore be difficult to specify.

(iii) Many service organizations have not previously had a costing system and much of the
information required to set up a ABC system will be non-existent. Therefore introduction of ABC
may be expensive.
16. How ABC system support corporate strategy?
(4 marks)
Solution
ABC supports corporate strategy in many ways such as:
 ABC system can effectively support the management by furnishing data, at the operational
level and strategic level. Accurate product costing will help the management to compare the
profits of various customers, product lines and to decide on price strategy etc.

 Information generated by ABC system can also encourage management to redesign the
products.

 ABC system can change the method of evaluation of new process technologies, to reduce
setup times, rationalization of plant lay out in order to reduce or lower material handling cost,
improve quality etc.

 ABC system will report on the resource spending.

 ABC analysis helps managers’ focus their attention and energy on improving activities and
the actions allow the insights from ABC to be translated into increased profits.

 Performance base accurate feedback can be provided to cost center managers.

 Accurate information on product costs enables better decisions to be made on pricing,

marketing, product design and product mix.
17. Why are conventional product costing systems more likely to distort product costs in highly
automated plants? How do Activity-Based Costing system deal with such a situation? (4 marks)

Solution
The conventional product cost system was in vogue when companies manufactured narrow range of
products, overhead costs were relatively small and distortions arising from inappropriate overhead
allocations were not significant. It used volume measures like direct labour hours or machine hours
for charging overhead costs to products. In the case of a company using highly automated plant,
direct labour is a small fraction of cost when compared with overheads (because of higher amount of
depreciation). In case where such a company is multi product, overheads which are large in
proportion to direct labour are influenced by number of set up, inspection, number of purchases etc.
In these circumstances, the volume based method of recovery of overheads is no longer appropriate
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and such a measure will report inaccurate products costs. Hence, the traditional system of costing
was found to over cost high volume products and under cost low volume products.

Activity Based Costing (ABC) system aims at refining the costing system used in automated plants in
the following manner:
1. ABC systems trace more costs as direct costs.
2. ABC systems create homogeneous cost pools linked to different activities.
3. For each activity cost pool, ABC systems seek a cost allocation base that has a cause-and-
effect relationship with costs in the cost pool.

18. How has the composition of manufacturing costs changed during recent years? How has this change
affected the design of cost accounting systems? (4 marks)

Solution
Traditionally, manufacturing companies classified the manufacturing costs to be allocated to the
products into (a) direct materials. (b) direct labour and (c) indirect manufacturing costs. In the
present day context, characterized by intensive global competition, large scale automation of
manufacturing process, computerization and product diversification to cater to the changing
consumer tastes and preferences has forced companies to refine their costing systems to provide
better measurement of the overhead costs used by different cost objects. According, manufacturing
costs are classified into the three broad categories as under:

1. Direct Cost: As Many total costs relating to cost objects as feasible are classified into direct
cost. The objective is to trace as many costs as possible into direct and to reduce the amount of
costs classified into indirect because the greater the proportion of direct costs the greater the
accuracy of the cost system.

2. Indirect cost pools: Increase the number of indirect cost pools so that each of these pools is
more homogeneous. In a homogeneous cost pool, all the costs will have the same cause-and-
effect relationship with the cost allocation base.

3. Use cost-and-effect criterion for identifying the cost allocation base for each indirect cost pool.

The change in the classification of manufacturing costs as above has lead to the development of
Activity Based Costing (ABC). Activity Based Costing refines a costing system by focusing on
individual activities as the fundamental cost objects. An activity is an event, task or unit of work with
a specified purpose as for example, designing, set up, etc. ABC system calculates the costs of
individual activities and assigns costs to cost objects such as products or services on the basis of the
activities consumed to produce the product or provide the service.

19. “Cost can be managed only at the point of commitment and not at the point of incidence. Therefore it
is necessary to manage cost drivers to mange cost.” Explain the statement with reference to
structural and executional cost drivers. (Marks 5)

Solution
A firm commits costs at the time of
1. designing the product
2. deciding about the method of production.
3. at the time of deciding the delivery channel (e.g. through dealers or own retail stores).

Costs are incurred at the time of actual production and delivery. Therefore, no significant cost
reduction can be achieved at the time when the costs are incurred.
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Therefore, it is said that costs can be managed at the point of commitment or cost lock-in period.
Cost drivers are factors that drive consumption of resources. So, management of cost drivers is
essential to manage costs.

Structural cost drivers are those, which can be managed by effecting structural changes. Examples
of structural cost drivers are scale of operation, scope of operation (i.e. degree of vertical
integration), complexity, technology and experience or learning. Thus, structural cost drivers arise
from the business model adopted by the company.

Executional cost drivers can be managed by executive decisions, examples of executional cost
drivers are capacity utilization, plant layout efficiency, product configuration and linkages with
suppliers and customers.

It is obvious that cost drivers can be managed only at the point of structural and operating decisions,
which commit resources to various activities.

20. In the context of Activity Based Costing System, explain the following statement: “Strategic cost
analysis should exploit internal linkages” (4 Marks)

Answer
Activity based costing is an accounting methodology that assigns cost to activities rather than to
products or services. Activity based Costing tracks the flow of activities by creating internal link
between activity/resource consumption and cost object. Exploiting internal linkages means taking
advantage of the relationships among the activities that exist within a firm’s segment of value chain.
Activity cost and analysis are essential parts of this strategic analysis. Activities not based on
production units/sales units, based on the variable activity drivers are analyzed. The traditional
costing system is not rich enough to supply the information needed for thorough analysis of linkages.

21. What do you mean by DPP? What are its benefits? (4 Marks)

Answer
Direct Product Profitability (DPP) is ‘Used primarily within the retail sector, and involves the
attribution of both the purchase price and other indirect costs such as distribution, warehousing,
retailing to each product line. Thus a net profit, as opposed to a gross profit, can be identified for
each product. The cost attribution process utilizes a variety of measures such as warehousing
space, transport time to reflect the resource consumption of individual products.’
Benefits of Direct Product Profitability:
(i) Better Cost Analysis - Cost per product is analysed to know the profitability of a particular
product.
(ii) Better Pricing Decision- It helps in price determination as desired margin can be added with the
actual cost.
(iii) Better Management of Store and Warehouse Space- Space Cost and Benefit from a product
can be analysed and it helps in management of store and warehouse in profitable way.
(iv) The Rationalisation of Product Ranges etc.

22. Explain - “ABC: A Decision Making Tool”.

Solution:
It is a useful tool for many of the management decisions facing companies today. It can bring a
picture of the operation to light that may not be obvious through other analysis tools. Specifically,
ABC is useful in analyzing specific segments of an organization. This might include a market line, a
group of products (even a single product), a customer, or an employee. The ABC is implemented in
following decisions:
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(i) ABC is a complement to total quality management (TQM). It provides quantitative data that can
track the financial impact of improvements implemented as part of the TQM initiative. Some
have even suggested that ABC is the most important concept introduced since TQM..
(ii) Wholesale distributors can gain significant advantage in the decision-making process through
implementation of ABC concepts. The expansion of line offerings has brought about difficult
decisions for the distributor.
(iii) Other decisions that can be assisted by ABC include facility and resource expansion. Often the
basis for relocation or opening of a new distribution center is based on cost associations. The
ABC model can identify the specific cost elements being targeted.
(v) Decision support for human resources can be augmented by ABC, where activity & it’s cost,
can be associated to an individual, new levels of financial performance can be determined.
(v) Companies who wish to determine price based on cost plus markup basis find ABC method of
costing very relevant and are able to determine competitive prices for their products.
(vi) Using Traditional absorption costing, overheads may get distributed equally across all
product lines. ABC traces costs with the activity and the consumption of resources by each
product. Thus, product line profitability can be determined in more realistic terms.
(vii) Other areas where ABC system can be relevant include market, make or buy decisions,
transfer pricing, plant close – down decision, evaluation of offshore production or outsourcing a
process, capital investment decisions, etc.
23. What is difference between ABC and ABM? (marks 2)

Solution:
The ABC refers to the technique for determining the cost of activities and the output. It is the logical
distribution of overhead i.e. overhead should be distributed on the consumption of resources by
goods and services. The aim of ABC is to generate improved cost data for use in managing a
company’s activities.
The ABM is a much broader concept. It refers to the management philosophy that focuses on the
planning, execution and measurement of activities as the key to competitive advantage.

24. What are the key elements of Activity Based Budgeting (ABB)? (Marks 3)

Solution:
The key elements of ABB are:
(i) Type of work/activity to be performed;
(ii) Quantity of work/activity to be performed; and
(iii) Cost of work/activity to be performed.

25. Point out the differences between activity based costing and traditional absorption costing.(Marks 4)

Solution:

Activity Based Costing Traditional Absorption Costing

(i) Overheads are related to activities and Overheads are related to cost centers /
grouped into activity cost pools. departments.
(ii) Activities are classified as – (i) Unit Level, (ii) Only (i) Unit Level (Variable) and (ii) Facility
Batch Level, (iii) Product Level and (iv) Level (Fixed) activities are identified.
Facility Level activities.
(iii) Cost are related to activities and hence are Costa are related to cost centers and hence
more realistic. not realistic of cost behavior.
(iv) Activitywise cost drivers are determined. Time (Hours) are assumed to be the only cost
driver governing costs in all departments.
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(vii) Activitywise recovery rates are determined Either multiple overhead recovery rate (for
and there is no concept of a single overhead each department) or a single overhead
recovery rate. recovery rate may be determined for
absorbing overheads.
(viii) Cost are assigned to cost objects, e.g. Costs are assigned to Cost Units i.e. to
customers, products, services, departments, products, or jobs or hours.
etc.
(ix) Essential activities can be simplified and
(vii) Cost Centers / departments cannot be
unnecessary activities can be eliminated. eliminated. Hence not suitable for cost control.
Thus the corresponding costs are also
reduced / minimized. Hence ABC aids cost
control.

26. Write a short note of ‘Batch Level Activities’.

Solution:

The cost of some activities (Mainly manufacturing support activities) is driven by the number of
batches of units produced. Examples of this are:

(i) Material Ordering – Where an order is placed for every batch of production.
(ii) Machine Set-up Costs – Where machines need resetting between each different batch of
production.
(iii) Inspection of Products – Where the first item in every batch is inspected rather than every 100 th
item quoted above.

27. State with a brief reason whether you would recommend an activity based system of costing in each
of the following independent situation:

(i) Company K produces one product. The overhead costs mainly consist of depreciation.
(ii) Company L produces 5 different products using different production facilities.
(iii) A consultancy firm consisting of lawyers, accountants and computer engineers provides
management consultancy services to clients.
(iv) Company S produces two different labour intensive products. The contribution per unit in both
products is very high. The BEP is very low. All the work is carried on efficiently to meet the
target costs.

Solution:

Description Recommend Reasons

No. ABC (Yes / No)
K produces one product. No  One product situation. For allocation of
Overhead is mainly overhead, ABC is not required.
depreciation.
 ABC for cost reduction not beneficial
since most of the overhead is
depreciation.
L produces 5 different Yes  Multi product situation. ABC is required
products with different for allocation of overhead.
facilities.
 ABC is necessary for pricing.
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 Cost drivers are likely to be different.

 Cost reduction may be possible.

 Production facilities are different.

Professional services – Yes  Variety of services. Hence ABC is
lawyers /accountants / required for cost allocation.
computer engineers.
 Services are very different.

 ABC is necessary for pricing.

 Cost reduction possible.

(iv) S produces 2 different No  Different products, but labour intensive.
labour intensive products. Hence, overhead allocation based on
High unit contribution and readily traceable direct labour cost will
efficient operation. be accurate. Hence, ABC not required
for cost allocation.

 Low BEP level implies low level of fixed

cost as a % of sale price or as a % of
total cost.

 Many fixed cost activity drivers are likely

to align with the direct labour costs.
Hence not required for cost allocation.

 Efficient operation. Hence ABC not

required even for cost reduction or BC
management.

28. Differentiate between ‘Value-added’ and ‘Non-value-added’ activities in the context of Activity based
costing. Give examples of Value-added and Non-value-added activities.

Answer:
A value added activity is an activity that customers receives extra usefulness from the product or
service as compare to its purchase price. So, it is an activity that increases the actual utility or
usefulness which customers obtain from using the product or service. For example, painting a car by
the manufacturing company or a computer manufacturing company making computers with
preloaded software.

A non-value added activity is an activity where there is an opportunity of cost reduction without
reducing the product’s utility. It is such an activity, if eliminated, will not reduce the perceived value to
the customers. For example, storage and moving of raw materials, reworking of products, etc.

Value-added activities enhance the value of products and services in the eyes of the organization’s
customers. Non-value added activities do not contribute to customer-perceived value.

29. State whether each of the following independent activities is value-added or non-value-added:

(i) Polishing of furniture used by a systems engineer in a software firm.

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(ii) Maintenance by a software company of receivables management software for a banking
company.

(iii) Painting of pencils manufactured by a pencil factory.

(iv) Cleaning of customers’ computer key boards by a computer repair centre.

(v) Providing, brake adjustments in cars received for service by a car service station.
(Marks 1 each)
Solution:

Item Value Added / Non

Value Added
Polishing furniture used by a Systems Engineer in a software firm. Non-Value Added
Maintenance by a software company of receivables management Value-Added
software for a banking company.
Painting of pencils manufactured by a pencil factory. Value-Added
(iv) Customers’ computer key board cleaning by a computer repair Value-Added
centre.
Providing brake adjustments in cars for repairs by a care service Value-Added
station.

Relevant costing & Decision making

1. Define the following terms:-
(i) Relevant cost
(ii) Differential cost
(iii) Opportunity cost
(iv) Sunk cost (2 marks each)

Answer:
(i) Relevant Cost: A relevant cost is a future cost that would arise as a direct consequence of the
decision under review. The relevant cost of a unit of production or sale is usually the variable cost
of that unit plus (or minus) any change in the total expend future on fixed costs. Identification of
relevant costs is very important for arriving at correct conclusions in the area of decision making.
(ii) Differential Cost: it is the increase or decrease in total cost or the change in specific element of cost
that results from any variation in operations. The increase or decrease in total cost may arise as a
result of producing or distribution , a few more or less of the products, a change in the method of
production or distribution, an addition or deletion of a product or a territory, and a selection of an
additional sales channel, etc. It is determined for choosing between competing alternatives.
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(iii) Opportunity Cost: An opportunity cost is the benefit foregone by selecting one alternative in
preference to another alternative. In other words, it is the benefit lost by diversion of an input factor
from one use to another. The amount of benefit lost is the opportunity cost of that input factor to be
considered while evaluating various alternatives.

(iv) Sunk Cost: A sunk cost is a cost incurred in the past. It may be associated with equipment or other
facilities which cannot be readily adopted to present or future purpose. Sunk cost is irrelevant to the
decision on hand.

2. “Relevant cost analysis helps in drawing the attention of managers to those elements of cost which
are relevant for the decision.” Comment (4 marks)
Answer
Relevant costs are pertinent costs for a decision. These costs change with the decisions to be
made. These are the future cash out flow to the decision. These costs generally respond to
managerial decision making. These costs are capable of making a difference in user-decisions and
enter into a choice between alternative courses of action.
Relevant costs are futuristic in nature. These are the costs that are expected to occur during the time
period covered by the decision. These costs are different between alternatives under consideration.

3. Briefly explain the implications of replacement costs and historical costs in financial reporting
(3 marks)
Answer

Historical cost is the actual cost of an asset at the time of its acquisition. Replacement cost is the
cost to be incurred on an asset if it is replaced. On these two cost concepts valuation of assets is
based for financial reporting purposes, differs because of price variations over a period of time. In
case the price of an asset remains the same with time then historical cost = replacement cost.
Under financial reporting viz. In the balance sheet assets are recorded at their historical cost. When
prices rise substantially over a period of time, historical cost do not properly indicate the actual costs.
For managerial decisions, therefore these costs should properly be adjusted for price changes. The
distinction between historical costs and replacement cost is thus relevant when past experience has
to be considered as a guide to future costs for a proposed course of action.

4. Give any three examples of opportunity cost. (3 marks)

Answer

(i) The opportunity of using a machine to produce a particular product is the earning foregone that
would have been possible if the machine was used to produce other products.

(ii) The opportunity cost of funds invested in a business is the interest that could have been
earned by investing the fund in bank deposit.

(iii) The opportunity cost of one’s time is the earning which he would have earned from his
profession.

5. Comment on the use of opportunity cost for the purpose of

(i) decision – making ; and
(ii) cost control. (4 marks)
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Answer
(i) Decision making : Opportunity costs apply to the of scarce sources, where resources are not
scarce, there is no sacrifice from the use of these resources. It is necessary to add the lost profit
in case of scarce resources.

If resources have no alternative use only the additional cash flow resulting from the course of
action should be included in decision making as relevant cost.

(ii) Cost control: if the budgeted optimum level of output can not be fulfilled due to inefficient usage
of scarce resources, then lost contribution should be charged to the manager responsible. This
can be computed as Contribution volume variance.
Thus if resources are scarce, the usage variance should be computed on basis of standard cost
plus budgeted contribution lost per unit of the scarce resources.

6. Explain with one example each that sunk cost is irrelevant in making decisions, but irrelevant costs
are not sunk costs. (2 marks)

Answer
Sunk cost is a historical cost incurred in the past. In other words it is a cost resource already
acquired. Further decision in respect of this resources will not be affected by it e.g. book value of
machinery. Hence sunk costs are irrelevant in decision making.
Irrelevant cost are not necessarily sunk costs. For example, in resale of material current purchase
price is non-relevant.

7. How the opportunity cost for inefficient use of scarce resources be presented in variance reports
under standard costing system?

Answer
Opportunity cost arise from the use scarce resources efficiently. For example, inefficient use of
scare materials results in lower production and loss of contribution. Similarly inefficient capacity
utilisation results in loss of production and consequently loss of contribution. Therefore, it is
appropriate to include contribution loss in reporting materials usage variance or labour efficiency
variance, in case the materials is scarce or labour hours is scarce. As a general rules loss of
contribution should be included in the variance report and should be assigned to the manager,
whose below standard performance has caused the loss.

8. “Relevant cost analysis help in drawing attention of managers to those elements of costs, which are
relevant for the decision.” Comment. (4 marks)

Answer
Business decision involves planning for the future and requires consideration of several alternative
choices. In making such decisions estimates of future costs and revenues are worked out. The
costs that matter in business decisions are only future costs.

Some important points are –

(i) Historical costs being sunk cost are not relevant to the decision.
(ii) Even among future costs, those variable costs ( book value of material) which do not differ
under various alternatives are not relevant.
(iii) If fixed expenses are committed under different alternatives, consider it non-relevant.
(iv) Book value of the equipment is not relevant because it is past cost.
 65
9. Explain the concept of relevancy of cost by citing three examples each of relevant costs and non-
relevant costs.

Answer
Examples of relevant costs are:
(1) All variable costs of future cash out flow are relevant costs.
(2) discretionary fixed costs which vary with the decision are relevant costs.
(3) Incremental costs are relevant costs.
Examples of non-relevant costs:
(1) All committed fixed costs are non-relevant.
(2) Variable costs, arises out of pasts are not relevant costs.
(3) Book value of the asset is not relevant.

10. Mention the important factors to be considered in Marginal Costing Decisions.

i. Whether the product or production makes a contribution, MR ≥ MC
ii. In the selection of alternatives, additional fixed costs if any should be considered , i.e.
discretionary fix cost.
iii. The continuity of demand after expansion & its impact on selling price are to be
considered i.e. inelastic or elastic demand.
iv. Compute total contribution & profit with the objective of maximising profit.
v. Non-cost factors such as the need to keep labour force intact and government attitude
are also to be taken into account.

Linear Programming
1. Definition:

Linear programming involves the construction of a mathematical model to represent the decision
problem where the activities of the problem constitute variables. The model then comprises a linear
function that is to be optimized and a set of restrictions on the variables in the form of linear
equations and inequalities. The model is then solved by an appropriate method or by the use of a
computer package to obtain the optimal values for the activities.

2. Pre condition for applying LPP:

i. The problem must be capable of being stated in numeric terms.

ii. All factors involved in the problem must have linear relationship.
iii. The problem must permit a choice or choices between alternative course of action.
iv. There must be more than one restrictions on the factors involved.
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3. Industrial & Management applications

Industrial Applications: Management Application:

a. Product Mix a. Financial Mix
b. Production scheduling b. Media selection
c. Transportation c. Traveling salesman.
d. Trim Loss d. Portfolio selection
e. Profit Planning

4. Limitations :

- It is assumed that the objective function and the constraints are linear functions. In practice step
costs might exist or resources might not be used at a constant rate throughout the entire output
range.

- Constraints are unlikely to be completely fixed. Some constraints can be removed at additional
costs.

- The output of the model is dependent on the accuracy of estimates used. It is difficult to
segregate costs into fixed and variable.

- Divisibility of product is not realistic in practice. Fraction of product cannot be produced in certain
cases.

- The graphical approach requires that only two variables (products) be considered.
- Qualitative factors are not considered.

5. Distinguish between Slack & Artificial Variable: check class note

6. Explain the limitations of linear programming. (4 marks)

Answer
Limitations of linear programming :
- It is assumed that the objective function and the constraints are linear functions. In practice step
costs might exist or resources might not be used at a constant rate throughout the entire output
range.
- Constraints are unlikely to be completely fixed. Some constraints can be removed at additional
costs.

- The output of the model is dependent on the accuracy of estimates used. It is difficult to
segregate costs into fixed and variable.

- Divisibility of product is not realistic in practice. Fraction of product cannot be prodced in certain
cases.
- The graphical approach requires that only two variables (products) be considered.
 67
- Qualitative factors are not considered.

7. Write a short note on the characteristics of the dual problem. (4 Marks)

Answer
Characteristic of the dual problem:

(i) For any linear programming model called primal model, there exists a companion model
called the dual model.
(ii) The number of constraints in the primal model equals the number of variables in the dual
model.
(iii) The number of variables in the primal model equals the number of constraints in the dual
model
(iv) If the primal model has a maximization objective then the dual model will have a minimization
objective and vice-versa. Inequalities get reversed.
(v) The solution of the primal model yields the solution of the dual model. Also, an optimal
simplex table for the dual model yields the optimal solution to the primal model. Further, the
objective functions of the two optimal tables will have identical values.
(vi) Dual of the dual problem is the original primal itself.
(vii) Feasible solutions to a primal and dual problem are both optimal if the complementary
slackness conditions hold. If this relationship does not hold either the primal solution or the
dual solution or both are not optimal.
(viii) If the primal problem has no optimal solution due to infeasibility, then the dual problem will
have no optimal solution due to unboundedness.
(ix) If primal has no optimal solution due to unboundedness, then the dual will have no optimal
solution due to infeasibility.

Throughput & Theory of Constraints: ( Drum-Buffer-Rope)

The theory of constraints (TOC) describes methods to maximize operating income when faced with some
bottleneck and some non bottleneck operations. The objective of TOC is to increase throughput contribution
while decreasing investments and operating costs. TOC considers a short – run time horizon & assumes
that operating costs are fixed costs.
TOC identifies three types of cost.
 Throughput contribution = Sales revenue- direct material cost.
(Direct material cost includes purchased components and materials handling costs.)
 Conversion costs : These are all fixed operating costs, ( excluding completely variable costs)
i.e. labour and overhead, including rent, utilities and relevant depreciation.
 Investments include all stock, raw material, work in progress, finished goods, research and
development costs, cost of equipment and buildings, etc.

1. The steps in managing bottleneck operations:

Step 1: Recognize that the bottleneck operation determines throughput contribution of the entire
system.
Step 2: Find the bottleneck operation by identifying operations with large quantities of inventory
waiting to be worked on.
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Step 3: Keep the bottleneck operation busy and subordinate all non bottleneck operations to the
bottleneck operation. That is, the needs of the bottleneck operation determine the
product schedule of non bottleneck operations.
The important concept behind TOC is that the production rate of the entire factory is set at the pace
of the bottleneck the constraining resource. Hence, in order to achieve the best result TOC
emphasizes the importance of removing bottlenecks or limiting factor

2. Throughput is influenced by : (2 marks)

 Selling price
 Direct purchase price
 Usage of direct materials
 Volume of throughput.

3. Constraints on throughput : (2 marks)

 the existence of an uncompetitive selling price
 the need to deliver on time to particular customers
 the lack of product quality and reliability
 the lack of reliable materials suppliers
 the existence of shortage of production resources.

4. Explain the theory of constraint (4 marks)

Answer
It helps the management to focus its attention on constraints and bottlenecks within the organisation.
In a manufacturing organization it concentrates on maximizing the rate of manufacturing output i.e.,
the throughput of the organisation, by examination of bottlenecks and constrains.

A bottleneck is an activity within the organisation where the demand for the resource is more than its
capacity to supply. A bottleneck is always a constraint but a constraint need not be a bottleneck.
Throughput is thus related directly to the ability to cope with the constraint and to manage the bottle
neck.

5. Explain the concept and aim of theory of constraints. What, are the key measures of theory of
constraints? (Marks 4)

Solution
The theory of constraints focuses its attention on constraints and bottlenecks within organisation.
The main concept is to maximize the rate of manufacturing output is the throughput of the
organisation. This requires to examine the bottlenecks and constraints. A bottleneck is an activity
within the organization where the demand for that resource is more than its capacity to supply, for
example lack of skilled labour, lack of customer orders, or the need to achieve high quality in product
output.
Key measures of theory of constraints:
(i) Throughput contribution: It is the rate at which the system generates profits through sales. It is
defined as, sales less completely variable cost, sales – direct are excluded. Labour costs tend
to be partially fixed and conferred are excluded normally.
(ii) Investments: This is the sum of material costs of direct materials, inventory, WIP, finished
goods inventory, R & D costs and costs of equipment and buildings.
(iii) Other operating costs: This equals all operating costs (other than direct materials) incurred to
earn throughput contribution. Other operating costs include salaries and wages, rent, utilities
and depreciation.

6. Classify the following items under the three measures used in the theory of constraints: (4 marks)
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(i) Research and Development Cost (ii) Rent/Utilities
(iii) Raw materials used for production (iv) Depreciation
(v) Labour Cost (vi) Stock of raw materials/wip/FG
(vii) Sales (viii) Cost of equipments and buildings.

Answer: The 3 Key measures are:

Through Contribution (iii) Raw Material for production

(vii) Sales

Operating Cost (ii) Rent/utilities

(iv) Depreciation
(v) Labour

Investments: (i) R& D

(vi) Raw Material Stock/wip/FG
(viii) Building and Equipment Cost

Transfer Pricing
Transfer price is the price at which goods or services are transferred from one unit of a concern to the other.
Various methods of pricing used for the purpose have been enumerated as below :-
i. At cost or variants of cost e.g., actual manufacturing cost; standard cost; full cost and full cost
plus mark up
ii. At market price;
iii. At bargained or negotiated prices.

Aims and features

Any transfer-pricing system should aim to

 ensure that resources are allocated in an optimal manner;
 promote goal congruence;
 motivate divisional managers;
 facilitate the assessment of management performance;
 retain divisional autonomy.
Its two overriding features should be
 simplicity in calculation and implementation;
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 robustness (i.e. not requiring frequent adjustment).

Needless to say, a number of these aims and features can conflict with each other, and prove difficult to
achieve in practice. It is highly unlikely that any one method would meet all the requirements of the firm in all
circumstance; the best that can be hoped for is a reasonable compromise.

Objectives:
1. As a profit centre, every division will try to maximise it’s own profit by transferring the product to
transferee at a high price or by selling it to the market. In this way the profit centre managers can
maximise their incentive & profit sharing bonus for the department.
2. Maximize the group profit of the company. Hence all the profit centers will have to adopt such a
transfer price which must not reduce the group profit.

1. Pricing at cost :
a. Actual manufacturing cost : According to this method goods or services are transferred at
their actual cost of production. It is a simple and useful method for units where responsibility
of profit performance is centralised.
b. Standard cost : Transfers of goods and services takes place at their standard cost.
Variances if arise are usually absorbed by the supplying unit but sometimes they may be
transferred to the user unit as well.
c. Full Cost : It means the sum total of expenses viz., cost of production, selling and
distribution, administration, research and development which is used as a transfer price. The
use of this method does not permit the internal unit to earn profit by transferring goods and
services internally, but permits them to do so while dealing with outsiders.
d. Full Cost plus : The supplying unit transfers goods and services at full cost plus (some mark-
up). The mark-up added to full cost is either expressed as a percentage of full cost or of
capital employed. Selling expenses here are recovered by the supplying unit without
incurring them, specially when the good/services are transferred internally. Due to this defect
the use of this method is not appreciated by the internal receiving units.

2. Market price method :

Under this method the transfer prices of goods/services transferred to other units/divisions are based
on market prices. In a competitive market goods/services cannot be transferred to its users at a
higher price. Such a competitive market provides an incentive to efficient production. The main
limitations of this method are :
i. Difficulty in obtaining just market prices.
ii. Difficulty in determining the elements of selling and distribution expenses such as
commission, discounts, advertisement and sales promotion etc., so that necessary
adjustment may be maid in the market price to provide benefit of these expenses to the profit
centre, receiving the goods.

3. Bargained/Negotiated prices method :

Each decentralised unit is treated as an independent unit and such units decide the transfer price by
bargaining or negotiations. Divisional managers have full freedom to purchase their requirement
from outside if the price quoted by their sister unit are not acceptable to them. A system of
negotiated price develops business like attitude amongst divisions of the company. The buying
division may be tempted to purchase from outside sources if the outside prices are lower than the
internal division’s price. In order to avoid any reduction in overall profits of the company, the top
management may impose restrictions on the external purchase / sale of goods.

4. Limitation of negotiated method of transfer pricing

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a. A system of negotiated prices develops business like attitude amongst divisions of a
company. This attitude may tempt the managers to purchase their requirements from outside
sources, even by, ignoring the overall interest of the company.

b. Agreed transfer price between divisions of a company, will depend on the negotiating skills
and bargaining power of the managers involved and the final outcome may not he close to
optimal level.
c. Conflict between divisions of a company may arise while negotiating about transfer price and
the resolution of such conflicts may require sufficient management time.
d. Measurement of divisional profitability may depend on the negotiating skills of the managers
who have unequal bargaining power.
e. Deciding about negotiated transfer price between the divisions of a company, is time-
consuming exercise for the managers involved.

5. International Transfer Price.

From a financial management standpoint, one of the distinguishing characteristics of the

multinational Corporation (MNC) is its ability to move money and profits among its affiliated
companies through internal transfer mechanisms. These mechanisms include transfer prices on
goods and services trade internally, inter-company loans, dividend payment, leading (speeding up)
and lagging (slowing down) inter-company payments, and fee and royalty charges.
Transfer pricing is a device used by MNC s to price inter- corporate exchange of goods, services,
technology, and capital in a manner designed to maximise overall after-tax profit. These products
and factor flows range from intermediate and finished goods to less tangible items such as
management skills, trademark, and patents.
Apart from tax- saving, transfer pricing may be used to serve for the following objectives:
i) Positioning of funds in locations that will suit corporate working capital policies.
ii) Reducing exchange exposure and circumventing exchange controls, restrictions on profit
repatriation so that transfers from affiliates to the parent can be maximised.
iii) Reducing customs duty payments and overcoming quota restrictions on imports.
iv) “Window dressing” operations to improve the apparent, i.e. reported financial position of an
officiate so that its credit rating may be enhanced.

The guidelines are based on the “arm’s length” price principle, that is a price that would have been
arrived at by two unrelated companies acting independently. There are three methods that the tax
authorities can use:

1. The comparable uncontrolled price method (which uses externally verified prices of similar
transactions involving unrelated companies)

2. The resale price method (which deducts a percentage from the selling price from the final
product to allow for profit) can be used when goods are ‘sold on’ with little further processing

3. The cost-plus method: an arm’s length gross margin is established and is applied to the seller’s
manufacturing cost.

6. Dual Pricing

The dual price method of transfer pricing was introduced in order to overcome the problems caused
by using marginal cost, namely poor morale in the selling division, and lack of motivation by the
receiving division to maximise the group’s profit. The dual pricing method uses two prices:
1. The supplying division is credited with a price based on total cost plus a mark-up.
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2. The receiving division is debited with marginal cost.

This means that the selling division is allowed to earn a profit and the receiving division has the
correct information in order to make the correct selling decision to maximise the group’s profit. The
difference between the two prices will be debited to a group account a transfer price adjustment
account. At the end of the year, the profits of the two divisions, and hence of the group, will be
overstated to the extent of the price difference. In order to correct this, the total amount in the
transfer price adjustment account must be subtracted from the two profits to arrive at the correct
profit for the group as a whole.

Dual pricing can also be used with market price in place of marginal cost for the receiving division.
This can aid the supplying division in a particular circumstance. For example, where market prices
are very volatile and the market price of the component suddenly collapses, it may be unrealistic to
expect the supplying division to cope with the decrease. Under these circumstances, the receiving
division would wish to buy else where if the transfer price set was higher than the market price. So,
the supplying division could be credited with total cost-plus and the receiving division debited with
the much reduced market price. The receiving division would then be happy to continue to buy
internally.

However, despite its advantages, dual pricing is not used widely in practice for the following reasons:
 It is a complicated system to operate when many goods are being transferred between a
number of different divisions.
 It involves head office in the accounting side and so notification of transactions must be sent to
the head office. Head office involvement goes against the principle of decentralisation and as a
result the managers of the divisions may feel they are not being given the freedom they might
expect as mangers of an autonomous division.
 If total cost plus and market price is used because prices have collapsed, it may cocoon the
divisional managers of the supplying division from the rigours of the market place.
 Total cost plus and marginal cost may not prove helpful either. Very few organisations require
the economic theory approach of using marginal costs to optimise profit, and taxation issues and
repatriation of funds are often of more importance when setting transfer prices.

7. Two- part tariff pricing:

Under this variant, the selling division transfers at marginal cost (including any opportunity cost), but
raises a fixed annual fee on the buying division for the privilege of receiving transfers at that price.
The theory underlying this approach is that the buying division will have a correct understanding of
the selling division’s cost behaviour patterns.

The buying division will be able to correctly identify the appropriate marginal cost when calculating
the optimum output level. The fixed fee is designed to cover a share of the selling division’s fixed
costs and provide a return on the capital employed in it, and thus both selling and buying division
should be able to record a profit on intra-company transfers.

Drawbacks of this system include:

 The supplying division has no incentive to supply units swiftly, because individual units do not
generate a profit.
 A profit is made when the fixed fee is transferred.

8. In transfer pricing what is common conflict between a division and the company as a whole.
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(6 marks)
Answer
Usually a conflict between a division of the company and the company as a whole is faced by the
management of decentralised units when products or services are exchanged among different
divisions of the company. Such a conflict becomes more significant in the case of those concerns
where profitability is used as a criteria for evaluating the performance of each division.

The essence of decentralisation is reflected in the freedom to make decisions. Under such a set up
it is expected that the top management should not interfere with the decision making process of its
profit centers. The management of such companies also expects that each profit centre should not
only achieve its own objective, but should also achieve the objective of goal congruence.

A divisional head in a company under aforesaid set up is free to use a price as a transfer price for
goods and services, which may provide incentive. Such a transfer price may fail to achieve the
objective of ‘Goal congruence’. In case of failure of a division to achieve the objective of ‘goal
congruence’ the management of the company may dictate their ‘transfer price’. So a group conflict
will arise.

Further this conflict is aggravated if the management advocates the transfer of goods and services at
cost. As at that transfer price performance of the transferring division can not be identified, as the
profit of the transferring division will be nil.

9. What should be the basis of transfer pricing, if unit variable cost and unit selling price are not
constant ? (4 marks)

Answer
If units variable cost and unit selling price are not constant then the main problem that would arise
while fixing the transfer price of a product would be as follows :
1. Find an optimum level of output for the firm as a whole. This is so because there is a
certain level of output beyond which its net revenue will not rise.
2. Apply the concept of IRDC to find the transfer price range. The ideal transfer price under
these circumstance will be that which will motivate these managers to produce at this level
of output.
10. What will be marketable transfer pricing regarding the goods transferred under the following
condition (each condition is under pendent of the other)?
(i) When divisions are not captives of internal divisions and free to do business both internally and
externally and when there are reasonably competitive external markets for the transferred
products.
(ii) If the external market for the transferred good is not reasonably competitive. (3 marks)

Answer.
Market Transfer pricing Procedure
(i) When divisions are not captives of internal divisions and the divisions are free to do business
both internally and externally and when there are reasonably competitive external markets for
the transferred products, then the most suitable transfer price would be, the market price, as it
generally leads to optimal decisions.
(ii) In case, the external market for the transferred good is not reasonably competitive, following two
situations may arise in this case.
(a) If there is idle capacity; Under this situation opportunity cost will be zero hence minimum
transfer price should be equal to the relevant costs incurred (sometimes = variable costs).
(b) If there is no idle capacity : transfer price = VC + DFC + OC.
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11. Discus the potential for maximization of income by a multinational through the use of transfer pricing
mechanism. (3 marks)

Answer.
The potential for maximisation of income by a multinational through the use of transfer pricing
mechanism is based on the successful implementation of the following steps :
(i) Transfer pricing may be set relatively higher in relatively high-tax countries so that purchase
inputs from relatively low-tax countries.
(ii) Transfer price is subject to import duties for goods or services purchase may be set low so as to
avoid host country taxes.
(iii) Transfer prices to a country with relatively high inflation may be set relatively high to avoid some
of the adverse effects of local currency devaluation.
(iv) Transfer prices may be set high for goods and services purchased by an affiliate operating in a
country that has imposed restrictions on the repatriation of income to foreign companies.
(v) Transfer prices may be set low to establish a competitive advantage over a local company either
to break into a market or to establish a higher share of the company’s business.

12. Outline the limitations of negotiated method of transfer pricing. (4marks)

Answer
Limitations of negotiated method of transfer pricing are as follows:
 A system of negotiated prices develops business like attitude amongst divisions of a company.
This attitude may tempt the managers to purchase their requirements from outside sources,
even by, ignoring the overall interest of the company
 Agreed transfer price between divisions of a company, will depend on the negotiating skills and
bargaining power of the managers involved and the final outcome may not he close to optimal
level.
 Conflict between divisions of a company may arise while negotiating about transfer price and
the resolution of such conflicts may require sufficient management time.
 Measurement of divisional profitability may depend on the negotiating skills of the mangers who
have unequal bargaining power.
 Deciding about negotiated transfer price between the divisions of a company, is time-consuming
exercise for the mangers involved.
Learning Curve
A Learning curve is a function that measures how labour-hours per unit decline as units of
production increase because workers are learning and becoming better at their jobs. Managers use
learning curves to predict how labour-hours, or labour costs, will decrease as more units are
produced.
The aircraft assembly industry first documented the effect that learning has on efficiency. In general,
as workers become more familiar with their tasks, their efficiency improves. Managers learn how to
improve the scheduling of work shifts. Plant operators learn how best to operate the facility. As a
result of improved efficiency, unit costs decrease as productivity increases, and the unit-cost function
behaves non-linearly. These non-linerities must be considered when estimating and predicting units
costs.
Managers are now extending the learning curve notion to other business functions in the value
chain, such as marketing, distribution, and customer service, and to costs other than labour costs.
The term experience curve describes this broader application of the learning curve. An Experience
curve is a function that measures the decline in cost per unit in various value chain functions such as
marketing, distribution, and so on, as units produced increase.

1. Experience curves:
Experience curves are very similar to learning curves. Learning curves deal only with labour hours
and therefore labour cost reducing by a set percentage. But experience curves cover all costs and
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yet they are very similar in percentage terms to learning curves. All costs reduce with experience to
some extent. Material costs may decrease slightly with quantity discounts etc., but will not decrease
by a large amount. Variable overheads often follow the pattern of direct labour and so may decrease
in a similar way. Fixed overheads will decrease per unit as more units are made and can also
decrease by a substantial amount per unit.

2. Uses of Learning curve. (marks 4)

i. L.C. helps in analysing cost-volume profit relationship and is useful for estimates and
forecasting
ii. L.C. helps in budgeting and profit planning
iii. L.C. helps in pricing, particularly in a tender when it is known that the tender consists of
several repetitive jobs
iv. L.C. helps design engineers in making decision, based upon expected rates of
improvement.
v. L.C. helps in setting standards in learning phase.
vi. L.C. knowledge helps in manpower planning for contract of long duration or for repetitive
work.
vii. LC suggest grate opportunities for cost reduction to be achieved by improving learning.
viii. LC concept provides a means of evaluating the effectiveness of training programs

3. Limitations to the usefulness of the Learning Curve: (marks 4)

1. The learning curve is useful only for new operations where machines do not constitute a major
part of the production process. It is not applicable to all productions. E.g. new and experienced
workmen.
2. The learning curve assumes that the production will continue without any major interruptions. If
for any reason the work in interrupted, the curve may be deflected or assume a new slope
3. Changes other than learning may effect the learning curve. For example, improvement in
facilities, arrangements, and equipment as well as personnel morale and performance may be
factors influencing the curve. On the other hand, negative developments in employee attitudes
may also affect the curve and reverse or retard the progress of improvement.
4. The characteristic 80 percent learning curve as originally obtaining in the air force industry in
U.S. A. has been usually accepted as the percentage applicable to all industries. Studies show
that there cannot be a unique percentage which can be universally applied.

4. Factors affecting Learning Curve: (marks 4)

1. While pricing for bids, general tendency is to set up a very high initial labour cost so as to show a
high learning curve. This makes the learning curve useless and sometimes misleading.

2. The method of production, i.e. whether it is labour oriented or machine oriented influences the
slop of the learning.

3. When labour turnover rate is high management has to train new workers frequently. In such
situations the company may never reach its maximum efficiency potential. One of the important
requisites of the learning curve concept is that there should be uninterrupted flow of work. The
fewer the interruptions, the grater will be the improvement in efficiency.

4. Changes in a product or in the methods of production, designs, machinery, or the tools/used

affect the slope of the learning curve. All these have the effect of starting learning a fresh
because of new conditions If the changes are frequent, there may be no learning at all.

5. Also other factors influencing the learning curve are labour strikes, lock outs and shut downs due
to other cause also/affect the learning curve. In each such case there is interruption in the
progress of learning.
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As far as possible the effects of above factors should be carefully separated from the data used to
establish the curve. The effects of these factors must also be separated from the actual costs used
to measure the performance. Unless this is done analysis of the projected cost or the actual cost will
not be meaningful.

Technique :
1. learning Equation

y = axb y = the average time or per unit time for x units

a = the time for the first unit
x = the cumulative number of units
b = the learning coefficient = log of learning %  log 2
So, log y = log a + b log x

2. The learning % is applicable with the time of 1 st unit when production volume is doubled
i.e. Y = a × LR no of double = a × y%.

3. Total time = x . y = x . axb = a . x (1+ b)

4. Apply the concept of Static cost & Reducible cost while prepare the Cost Sheet .

5. Learning curve ratio = average labour cost of first 2n units ÷ Average labour cost of first
n units.

6. Apply high low pt. method to determine the learning rate : a × LR no of double = last average
time

5. State the areas in which the application of learning curve theory can help a manufacturing organisation
(marks 3)
Answer
The areas in which the application of learning curve can help manufacturing organisation are:
 Improvement of productivity – As the experience is gained, the performance of works improves,
time taken per unit reduces and thus his productivity goes up.
 Cost prediction – Learning curve provides better cost predictions to enable price quotations to
be preferred for potential orders.
 Work scheduling – Learning curve enables us predict the inputs required more effectively and
helps in the preparation of accurate delivery schedules.
 Standards setting – If budgets and standards are set without considering learning curve, it is
meaning less because variances will arise.

6. The following information is provided by a firm. The factory manager wants to use appropriate
average learning rate on activities so that he may forecast costs & prices for certain levels of activity.
(i) A set of very experienced people feed data into the computer for processing inventory records
in the factory. The manager wishes to apply 80% learning rate on data entry and calculation of
inventory.
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(ii) A new type of machinery is to be installed in the factory. This is patented process and the
output may take a year for full fledged production. The factory manager wants to use a
learning rate on the workers at the new machine.
(iii) An operation uses contract labour. The contractor shifts people among various jobs once in
two days. The labour force performs one task in 3 days. The manager wants to apply an
average learning rate for these workers.
You are required to advise to the manager with reasons on the applicability of the learning curve
theory on the above information. (Marks 4)

Solution
The learning curve does not apply to very experienced people for the same job, since time taken can
never tend to become zero or reduce very considerably after a certain range of output. This is the
limitation of the learning curve.
(i) Data entry is a manual job so learning rate theory may be applied. Calculation of inventory is a
computerized job. Learning rate applies only to manual labour.
(ii) Learning rate should not be applied to a new process which the firm has never tried before.
(iii) The workers are shifted even before completion of one unit of work. Hence learning rate will
not apply.

7. Explain distinctive features of learning curve theory in manufacturing environment. (4 marks)

Solution: The distinctive features of a learning curve are:

(1) Better tooling methods are developed and used
(2) More productive equipments and designed and used to make the product
(3) Design bugs are detected and corrected.
(4) Better design engineering reduces material and labour costs.
(5) Early teething problems are overcome. As production progresses management is prompted
to achieve better planning and better management.
(6) Rejections and rework tend to diminish over time
(7) AS quantity produced increases the cost per unit decreases, since each unit entails:
(i) Lesser Labour;
(ii) Greater productivity of material & labour;
(iii) Fewer delays and lesser time losses.
8. State whether the learning curve theory can be applied to the following independent situations briefly
justifying your decision : (4 Marks)
(i) A labour intensive sculpted product is carved from the metal provided to the staff. The metal is
sourced from different suppliers since it is scarce. The alloy composition of the input metal is
quite different among the suppliers.
(ii) Pieces of hand-made furniture are assembled by the company in a far off location. The
labourers do not know anything about the final product which utilizes their work. As a matter of
further precaution, rotation of labour is done frequently.
(iii) Skilled workers have been employed for a long time. The company has adequate market for
the craft pieces done by these experts.
(iv) A company finds that it always has an adverse usage of indirect material. It wants to apply
learning curve theory to improve the way standards have been set.

Answer
(i) ‘Learning Curve Theory’ will not be applicable as alloy combination of the input metal is quite
different among the suppliers hence learning experience with one type of metal may not be
beneficial for the workers to deal with other metal with separate alloy composition.
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(ii) ‘Learning Curve Theory’ will not be applicable as in this situation rotation of labour is done
frequently, labours will not be able to get the benefit of learning and apply their learning.
Hence, learning curve theory can not be applied.
(iii) ‘Learning Curve Theory’ will not be applicable as in this situation as workers are skilled and
employed for a long time, they have already achieved maximum level of expertise by taking
advantage of learning. Hence, at this point of time learning curve theory can not be applied.
(iv) ‘Learning Curve Theory’ will not be applicable as indirect materials are the materials which are
not used directly in the production (not directly proportionate with volume of output) and usually
used machines (e.g. lubricants, spares parts etc.) with less human interactions. Adverse usage
of indirect materials can be controlled through proper monitoring and appropriate standard
settings and not from applying learning curve theory.

9. Explain the learning curve ratio.

Solution:
As the production quantity of a given item is doubled, the cost of the item decreases at a fixed rate.
This phenomenon is the basic premise on which the theory of learning curve has been formulated.
As the quantity produced doubles, the absolute amount of cost increase will be successively smaller
but the rate of decrease will remain fixed.
It the initial stage of a new product or a new process, the learning effect pattern is so regular that the
rate of decline established at the outset can be used to predict labour cost well in advance. The
effect of experience on cost is summarized in the learning curve ratio or improvement ratio.

Learning curve ratio = Average labour cost of first 2N untis

Average labour cost of first N units
For example, if the average labour cost for the first 500 units is 25 and the average labour cost for
the first 1,000 units is 20, the learning curve ratio is ( 20/25) or 80%. Since the average cost per
unit of 1,000 units is 20, the average cost per unit of first 2,000 units is likely to be 80% of 20 or
16.

Life Cycle Costing

1. What is total life cycle costing? (4 marks)

Life cycle costing is a methodology for calculating the whole cost of a system from
inception to disposal. The system will vary from industry to industry and could for instance
be a building, a ship, a weapon system or a power station. Whatever the system, the life
cycle costing technique will be the same.
The major items of cost will be defined through its life. These items could include research
and development, construction, operation and maintenance and disposal. The items may be
further subdivided until the cost of each element can be defined as a mathematical
equation. At a simple level this may be the number of man-hours multiplied by a cost rate.
The elements of cost will then be added together to give the total cost for each item and a
grand total for the system through its full life.
So, cost p.u. = total cost during life cycle ÷ total no. of units
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Life cycle costing is a technique which takes account of the total cost of making a product
or owning a physical asset, during its economic life.
The production and sale of many products follow a cycle over their economic lives.
Normally, sales start out slow, expand rapidly as the product is popularised and then drop
off rapidly as a better product becomes available or a new product emerges in the market.
Therefore, each product takes a number of years (accounting periods) to complete the
cycle. The figure given below shows through different phases in the life cycle, a product too
has similar phases.

2. Phases of Product Life Cycle:

PLC of New Product
Sales
Units Introduction Maturity Decline
Revenue Line
Growth
Time

Profit Line
Stage I Introduction (Childhood)
II Growth (Adulthood)
III Maturity (Manhood)
IV Decline (Old age and Death)

(i) Introductory phase

Demand will be low when a product is first launched onto the market, and heavy advertising
expenditure will usually be required to bring it to consumers’ attention. The aim is to establish the
product in the market, which means achieving a certain critical mass within a certain period of time.
The critical mass is the sales volume that must be achieved in order to make the product viable in
the medium term. Depending on the nature of the product, a price penetration (low entry price) policy
may be adopted in order to reach the critical mass quickly. On the other hand the market may be
skimmed (exploiting those purchasers keen to have the latest product such as LED & 3D TVs and so
a high introductory price may be set.

(ii) Growth
Once the hurdle of the introductory stage has been successfully negotiated, the product enters the
growth stage, where demand shows a steady and often rapid increase. The cost per unit falls
because of economies of scale with the greater level of production. The aim at this stage is to
establish a large market share and to perhaps become the market leader. Market share is easier to
obtain during the growth stage because the market is growing and increased market share does not
have to be gained by taking sales from another company. In a more mature market, market share
has to be poached from competitors and their reaction may be unpleasant as they try to hold on to
their market share. During the growth stage competitors will enter the market, some of which will not
survive into the maturity state. Despite the fact that competing products will be launched into the
growing market and pricing is often keen in order to gain market share, it is usually the most
profitable stage for the initial supplier.

(iii) Maturity
The increase in demand slows down in this stage, as the product reaches the mass market. The
sales curve flattens out and eventually begins to fall. As market maturity is reached the organisation
becomes more interested in minimizing elasticity. Products have to be differentiated in order to
maintain their position in the market and new users for mature products need to be found to keep
demand high. Generally, Profits will be lower than during the growth stage.
 80

(iv) Decline
When the market reaches saturation point, the product’s sales curve begins to decline. When the
market declines price wars erupt as organisations with products which have elastic demand seek to
maintain full utilisation of their production capacity.
Profits can still be made during the early part of this stage, and the products will be managed to
generate cash for newer products. This will determine how prices are set. Eventually rapidly falling
sales inevitably result in losses for all suppliers who stay in the market. This particular product has
effectively come to the end of its life cycle, and alternative investment opportunities must be
pursued.
Despite the recent general tendency to shorter life cycles, the length of any particular stage within
the cycle and the total length of the life cycle itself will depend on the type of product or service being
marketed. Although the curve will be characterized by a sustained rise, followed by leveling out and
falling away, the precise shape of the curve can vary considerably. Life cycles are discussed further
later in this text.

3. The length of the product cycle is governed by the rate of (2 marks)

(a) technological change (b) market acceptance and (c) competition.

4. Uses of PLC : (3 marks)

(i) as a Planning tool, it characterises the marketing challenges in each stage and poses
major alternative strategies. i.e. application of Kaizen.
(ii) as a Control tool, the launched PLC concept allows the company to measure product
performance against similar products launched in the past.
(iii) as a Forecasting tool, it is less useful because sales histories exhibit diverse patterns
and the stages vary in duration.

5. Explain the essential features of Life cycle costing. (3 Marks)

Solution
Essential features of Life Cycle Costing:
Product Life Cycle costing involves
Tracing of costs and revenue of product over several calendar period. Throughout their entire

life cycle.
Emphasis is on Cost and revenue accumulation over the entire life cycle of the product.

Life cycle costing traces research and design.

It focus on development costs, incurred to individual products over their entire life cycles.

Total magnitude of research and development costs are reported and compared with product

revenues generated in later periods.

6. Importance: (4 marks)

1. When non-production costs like cost associated with R & D, design, marketing, distribution and
customer service are significant, it is essential to identify them for target pricing, value
engineering and Cost Management. For example, a poorly designed software package may
involve higher costs on marketing, distribution and after sale service.

2. When a high percentage R&D cost of total life cycle costs are likely to be incurred before the
commencement of production, the firm needs an accurate prediction of costs and revenues
during the manufacturing stage to decide whether the costly R & D and design activities should
be undertaken.
 81
3. Many costs are locked in at R & D and design stages. For example, the adoption of a certain
design will determine the product’s material and labour inputs to be incurred during the
manufacturing stage. A complicated design may lead to greater expenditure on material and
labour costs every time the product is produced. Life cycle budgeting highlights costs throughout
the product life cycle and facilitates value engineering at the design stage before costs are
locked in.
4. Total life cycle costing approach accumulates product costs over the value chain. It is a process
of managing all costs along the value chain starting from product’s design, development,
manufacturing, marketing, service and finally disposal.

7. Stages of product life cycle (4 marks)

(i)Market research: It identified – the products which customers wants, how much they are
prepared to pay for it and how much quantity they intend to buy.
(ii) Specification: It provides details such as required life; maximum permissible maintenance
costs, manufacturing costs, units required, delivery date, expected performance of the
product.
(iii) Design: Proper drawings and process schedules are defined.
(iv) Prototype manufacture: Prototype may be used to develop the product and eventually to
demonstrate that it meets the requirements of the specifications.
(v) Development: Testing and changing to meet the requirements after the initial run as a
product when first made rarely meets the specification.
(vi) Tooling: Tooling up for production means building a production line, building expensive
jigs, buying the necessary tool and equipments.
(vii) Manufacture: It involves the purchase of raw material and components., use of labour to
make and assemble the product.
(viii) Selling: creating demand for the product when the product is available for sale.
(ix) Distribution: The product should be distributed to the sales outlets and to the customers.
(x) Product support: The manufacturer or supplier should make sure that spares and expert
servicing facilities are available for the entire life of the product.
(xi) Decommissioning: When a manufacturing product comes to an end, the plant used to
build the product must be sold or scrapped.
8. Costs included in different stages of PLC (3 marks)
1. Development phase: R & D cost/Design cost. (Max.) (Cost locks in)
2. Introduction phase: Promotional Cost/Capacity costs.
3. Growth phase/Maturity: Manufacturing Cost/Distribution Costs/Product support cost.
4. Decline /Replacement phase: Plants reused/sold/related costs i.e. project clean up cost.

9. Benefit of product life-cycle costing. (3 marks)

i) It results in earlier action to generate revenue or to lower costs than otherwise might be
considered.
ii) Better decisions should follows from a more accurate and realistic assessment of revenues and
costs, within a particular life cycle stage.
iii) It can promote long term rewarding in contrast to short term profitability rewarding.
iv) It provides an overall framework for considering total incremental costs over the entire life span
of a product.

10. Summary of the characteristics

Sales
Introduction Maturity Decline

Growth Time
S T A G E S
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Low Rapidly Peak Declining Sales

Sales Rising Sales Sales
Sales

Positive Rising Positive, but Z Zero or Growth

Growth growth declining Negative

High Cost Average Low cost Low cost Cost

Per Cost per Per Per
Customer Customer Customer Customer

Negative Rising High Decline Profits

Profit Profit Profit

Innovators Early Middle Laggards Customer

Adopters Majority

No Different Model

Declining Number Competitors

Few Growing State Number begin to Decline (Same Level)
Number

11. One practical approach of PLC

Meena is a news reporter and feature writer for an economic daily. Her assignment is to. develop a
feature article on 'Product Life-cycle Costing', including interviews with the' Chief Financial Officers
(CFO) and operating, managers. Meena has been given a liberal budget for travel so as to research
into company's history, operations, and market analysis for the firm she selects for the article. Meena
has asked you to recommend industries and firms that would be good candidates for the article.
What would you advice? Explain your recommendations. (4 marks)

Answer :
The PLC span the time from the initial R & D on a product to when customer service and support is
no longer offered for that product.

Life Cycle Costing technique is particularly important when:

(a) High percentage of total life-cycle costs are incurred before production begins and revenue are
earned over several years and
(b) High fraction of the life cycle costs are locked in at the R & D and design stages.
Meena should identify those industries and then companies belonging to those industries where
above mentioned feature are prevalent. For example, Automobile and Pharmaceutical Industries
companies like Tata Automobile, M&M, Ranbaxy and Dabur will be good candidates for study on
product life cycle costing.

12. Fiona is a news reporter and feature writer for an economic daily. Her assignment is to develop a
feature article on ‘Product Life-Cycle Costing’, including interviews with the Chief Financial Officers
 83
(CFO) and Operating Managers. Fiona has been given a liberal budget for travel so as to research
into company’s history, operations, and market analysis for the firm she selects for the article.
Required:
Fiona has asked you to recommend industries and firms that would be good candidates for the
article. What would you advice? Explain your recommendations. ` (4 marks)

Solution:
The product life cycle span the time form the initial R & D on a product to when customer service and
support is no longer offered for that product.
Life Cycle Costing technique is particularly important when:
(i) High percentage of total life-cycle costs are incurred before production begins and revenue
are earned over several years and
(ii) High fraction of the life cycle costs are locked in at the R & D and design stages.
Fiona should identity those industries and then companies belonging to those industries where
above mentioned feature are prevalent. For example, Automobile and Pharmaceutical Industries
companies like Tata Motors Ltd., Ranbaxy Laboratories Ltd., and Dabur India Ltd. will be good
candidates for study on product life cycle costing.

Value Analysis or Value Engineering or Value Chain

Value analysis is a systematic interdisciplinary examination of factors affecting the cost of a
product or service in order to devise means of achieving the specified purpose at the
required standard of quality and reliability at the target cost.
The aim of value engineering is to achieve the assigned target cost by
(i) Identifying improved product designs that reduce the product’s cost without
sacrificing its utility and/or
(ii) Eliminating unnecessary functions that increase the product’s costs and for which
customers are not prepared to pay extra.
Value analysis or value engineering is one of the most widely used cost reduction techniques. It can
be defined as a technique that yields value improvement.
It investigates into the economic attributes of value. It attempts to reduce cost through
a. design change,
b. modification of material specification,
c. change in the source of supply and so on.

Suppliers Organisation Customers

Research
& Design production Marketing Distribution Customer
Development Service
 84
It emphasizes on finding new ways of getting equal or better performance from a product at a lesser
cost without affecting its quality, function, utility and reliability. For example, the function of a
fastener is to join two or more parts. Value analysis examines the value of this function in terms of
alternative methods such as welding, taping stapling, etc. in view of the stress and vibrations
involved in a specific application.
In value analysis each and every product or component of a product is subjected to a critical
examination so as to ascertain its utility in the product, its cost, cost benefit ratio, and better
substitute etc. When the benefits are lower than the cost, advantage may be gained by giving up the
activity concerned or replacing if for betterment. The best product is one that will perform
satisfactorily at the lowest cost.
The various steps involved in value analysis are :
1. identification of the problem;
2. collecting information about function, design, material, labour overhead costs,
etc., of the product and finding out the availability of the competitive products
in the market; and
3. exploring and evaluating alternatives and developing them.
In other words value analysis brings out clearly the areas where the cost of a product can be
reduced by pointing out :
1. Unnecessary items, components in a product to be removed.
2. Possibility of substitution with reduced cost without affecting its quality.
3. Possibility of overall simplification in design manufacture etc. of a product.

1. Value analysis in cost reduction :: (3 marks)

 By identifying and removing unnecessary components in a product which had utility earlier.
 By introducing component substitution at a lesser cost without affecting the quality of the product.
 By simplifying the product design.
 By introducing alternative methods with less cost but improved efficiency.
2. State whether each of the following independent activities is value-added or non-value-added:
(i) Polishing of furniture used by a systems engineer in a software firm.
(ii) Maintenance by a software company of receivables management software for a banking
company.
(iii) Painting of pencils manufactured by a pencil factory.
(iv) Cleaning of customers’ computer key boards by a computer repair centre.
(v) Providing, brake adjustments in cars received for service by a car service station.

Answer ( 2 marks each)

SI. No Item
Polishing furniture used by a Systems Engineer in a software firm Non-value added
Maintenance by a software company of receivables management Value-added
software for a banking company
Painting of pencils manufactured by a pencil factory Value-added
Customers’ computer key board cleaning by a computer repair Value-added
centre
Providing brake adjustments in cars for repairs by a care service Value-added
station.

3. In Value Chain analysis, business activities are classified into primary activities and support
activities. Classify the following under the more appropriate activity.

(i) Order processing and distribution

(ii) Installation, repair and parts replacement
(iii) Purchase of raw material and other consumable stores
(iv) Transforming inputs into final products
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(v) Selection, promotion, appraisal and employee relations
(vi) Material handling and warehousing
(vii) General management, planning, finance, accounting
(viii) Communication, pricing and channel management (1 mark each)

Answer
Activity Primary
Activity/Support
Activity
(i) Order processing and distribution Primary Activity
(ii) Installation, repair and parts replacement Primary Activity
(iii) Purchase of raw material and other consumable stores Support Activity
(iv) Transforming inputs into final products Primary Activity
(v) Selection promotion, appraisal and employee relations Support Activity
(vi) Material handling and warehousing Primary Activity
(vii) General management, planning, finance, accounting Support Activity
(vii) Communication, pricing and channel management Primary Activity

4. Internal Differentiation Analysis: (3 marks)

It requires firms to first identify their value-creating processes and primary cost drivers. They are
then ready to perform a differentiation analysis using the following guidelines:
1. Identify the Customers’ value-creating processes;
2. Evaluate differentiation strategies for enhancing customer value; and
3. Determine the best sustainable differentiation strategies.
Guidelines
1. Identify the customers’ value-creating process.
2. Evaluate differentiation strategies for enhancing customer value.
3. Determine the best sustainable differentiation strategies

5. Value Chain vs. Traditional Management Accounting (4 marks)

Traditional Management Accounting Value Chain Analysis in the strategic

Framework
1 If focuses on internal information Focuses on external information.
2. Application of single cost driver at the Application of multiple cost drivers i.e.
overall firm level is taken. structural and executional are taken
foreach value activity.
3 It assume that cost reduction must be Exploits linkages throughout the value
found in the value added process chain i.e. within firm, with suppliers and
customers.
4. Insights for strategic decisions somewhat Identity cost driver at the individual activity
limited in traditional management level and develop cost /differentiation
accounting advantage either by controlling those
drivers better than competitors by
reconfiguring the value chain.

6. Vertical linkage Analysis

Linkages among value creating processes do not end with the activities within a firm. The greatest
competitive advantage may come out of linkages between a firm’s value creating activities and those
of its suppliers, channels or users.

Vertical linkage analysis is a much broader application of inter cost & difference analysis that
includes all upstream & downstream value creating processes throughout the industry. Vertical
 86
linkage analysis considers all links from the source of raw materials to the disposal and/or recycling
of the product.

Vertical linkage can reveal which activities are the most (and least critical to competitive advantage
(or disadvantage). For example, Swiss watchmakers succeeded for years as relatively small, labour
intensive assemblers. Then came the 1970s and the advent of low cost, mass-produced watches.
The Swiss responded by restructuring their industry to gain economies of scale similar to those
enjoyed by their global competitors.

7. Limitations of value chain analysis (4 marks)

1. Non-availability of Data: Internal data on costs, revenues and assets used for Value Chain
Analysis are derived from financial information of a single period. For long-term strategic
decision-making, changes in cost structures, market prices and capital investments etc. may not
be readily available.

2. Identification of Stages: Identifying stages in an industry’s Value Chain is limited by the ability to
locate at least one firm that participates in a specific stage. Breaking a value stage into two or
more stage when an outside firm does not compete in these stages is strictly judgment.

3. Ascertainment of Costs, Revenue and Assets: Finding the Costs, Revenues and Assets for each
Value Chain activity poses/ gives rise to serious difficulties. There is no scientific approach and
much depends upon trial and error and experimentation methods.

4. Identification of Cost Drivers: Isolating cost Drivers for each Value-creating activity, identifying
Value Chain Linkages across activities, and computing supplier and customer profit margins
present serious challenges.

5. Resistance from Employees: Value Chain Analysis is not easily understandable to all employees
and hence may face resistance from employees as well as managers.

8. Differentiate between ‘Value-added and Non-value-added’ activities in the context of Activity-Based

Costing. Give examples of Value-added and Non-value-added activities (4 marks)

Solution
A value added activity is an activity that customers perceive as adding usefulness to the product or
service they purchase. In other words, it is an activity that, if eliminated, will reduce the actual utility
of usefulness which customers obtain from using the product or service. For example, painting a car
in a company manufacturing cars or a computer manufacturing company making computers with
preloaded software.
A non-value added activity is an activity where there is an opportunity of cost reduction without
reducing the product’s service potential to the customer. In other words, it is an activity that, if
eliminated, will not reduce the actual or perceived value that customers obtain by using the product
or service. For example, storage and moving of raw materials, reworking or repairing of products,
etc.
Value added activities enhance the value of products and services in the eyes of the organization’s
customers while meeting its own goals. Non-value added activities on the other hand do not
contribute to customer-perceived value.

9. Explain with a diagram the value chain activities within the firm with suitable classifications under
primary and support activities and also the industry value chain indicating what the end use
consumer pays for. 5 marks

Solution
 87
Industry value chain Value chain activities
within the firm
Primary Activities Support
Activities
End use consumer pays for profit margin throughout

Supplier value R&D

chan Procure
ment

Design
X Y Firm Z value
chain
Technology
development
Production

Distribution
value
chain Human
Marketing resource
management

Disposal
recycle Distribution
value
Firminfrast
Service urce

10. Explain, how does value chain approach helps an organisation to assess its competitive advantage.
(3 marks)
Answer
The way the value chain approach helps firms to assess competitive advantage includes the use of
following steps of analysis :

(i) Internal cost analysis -- to determine the sources of profitability and the relative cost position if
internal value creating processes.
(ii) Internal differentiation analysis – to understand the sources of differentiation (including the cost)
within internal value creating processes, and
(iii) Vertical linkage analysis – to understand the relationships and associated costs among external
suppliers and customer in order to maximize the value delivered to customers and to minimise
cost.

These type of analysis are not mutually exclusive. In fact, firm begin by focusing on their internal
operations and gradually widening their focus to consider their competitive position within their
industry. The value chain approach used for assessing competitive advantage is an integral part of
the strategic planning process.

11. Mention three 'useful strategic frameworks of the value chain analysis. (Marks 4)

Answer
Three useful strategic frameworks for value chain analysis are:
 88
 Industry structure analysis;
 Core competencies; and
 Segmentation analysis.

12. State whether the following independent activities is value-added or non-value-added: ( 5 marks)
i. Polishing of furniture used by a systems engineer in a software firm.
ii. Maintenance by a software company of receivables management software for a banking
company.
iii. Painting of pencils manufactured by a pencil factory.
iv. Cleaning of customers’ computer key boards by a computer repair centre.
v. Providing, brake adjustments in cars received for service by a car service station. (5 Marks)

Answers
SI. No Item
i) Polishing furniture used by a Systems Engineer in a software firm Non-value
added
ii) Maintenance by a software company of receivables management software Value-
for a banking company added
iii) Painting of pencils manufactured by a pencil factory Value-
added
iv) Customers’ computer key board cleaning by a computer repair centre Value-
added
v) Providing brake adjustments in cars for repairs by a care service station. Value-
added

13. What are the limitation of Value Chain Analysis.

Solution:

(i) Non-availability of data: Internal data on costs, revenues and assets used for value chain
analysis are derived from financial information of a single period. For long term strategic
decision making, changes in cost structures, market prices and capital investments etc. may
not be readily available.

(ii) Identification of stages: Identifying stages in an industry’s value chain is limited by the ability
to locate at least one firm that participates in a specific stage. Breaking a value stage into two
or more stages when an outside firm does not complete in these stages is strictly judgment.

(iii) Ascertainment of cost, revenues and assets: Finding the costs revenues and assets for
each value chain activity poses / gives rise to serious difficulties. There is no scientific
approach and much depends upon trial and error and experimentation methods.

(iv) Identification of cost drivers: Isolating cost drivers for each value-creating activity, identifying
value chain linkages across activities and computing supplier and customer profit margins
present serious challenges.

(v) Resistance from employees: Value chain analysis is not easily understandable to all
employees and hence may face resistance from employees as well as managers.
 89
(vi) Science vs. Art: Value chain analysis is not exact science. It is more “art” than preparing
precise accounting reports. Certain judgments and factors of analysis are purely subjective and
differ from person to person.

Target Costing
Target costing is a customer-oriented technique that is widely used by Japanese companies and
which has recently been adopted by companies in Europe and the USA. This approach was first
developed in Japan in the 1970s by companies such as Sony and Toyota.
Instead of using cost-plus pricing whereby cost is used as the starting point to determine the selling
price, target costing is the reverse of this process. With target costing the starting point is the
determination of the target selling price. Next a standard or desired profit margin is deducted to get a
target cost for the product. The estimated future cost will not be higher than the target cost.

The first stage requires market research to determine the customers’ perceived value of the product,
its differentiation value relative to competing products and the price of competing products. The
target profit margin depends on the planned return on investment for the organization as a whole
and profit as a percentage of sales. This is then decomposed into a target profit for each product
which is then deducted from the target price to give the target cost. The target cost is compared with
the predicted actual cost. If the predicted actual cost is above the target cost intensive efforts are
made to close the gap. Product designers focus on modifying the design of the product so that it
becomes cheaper to product. Manufacturing engineers also concentrate on methods of improving
production processes and efficiencies.

The aim is to drive the predicted actual cost down to the target cost but if the target cost cannot be
achieved at the pre-production stage the product may still be launched if management are confident
 90
that the process of continuous improvement and learning curve effects will enable the target cost to
be achieved early in the product’s life. If this is not possible the product will not be launched.

The major attraction of target costing is that marketing factors and customer research provide the
basis for determining selling price whereas cost tends to be the dominant factor with cost-plus
pricing. A further attraction is that the approach requires the collaboration of product designers,
production engineers, marketing and finance staff whose focus is on managing costs at the product
design stage. At this stage costs can be most effectively managed because a decision to committing
the firm to incur costs will not have been made.

Target costing is most suited for setting prices for non-customized and high sales volume products. It
is also an important mechanism for managing the cost of future products.

Implementation (4 Marks)

There are five main steps in developing target prices and target costs.

Step 1 : Develop an idea for a product that satisfies Needs of potential customers

Step 2 : Select a Target Sale Price for the product through proper market survey.

Step 3 : Derive Target Cost p.u. = Target Price p.u. - Target profit p.u

Step 4 : Perform Value Engineering Learning Curve to achieve total estimated cost.

Step 5 : if the total estimated cost as computed on basis of life cycle ≤ total target cost , then the
project will start.

1. Target costing support system (4 Marks)

It should be clear that target cannot operate in isolation; support systems are needed to feed it
information. Kato (1993)listed the support systems needed in order to operated target costing
successfully. They are as follows.

1. Sales pricing support systems : These are market research system, which have the following
qualities :

 An ability to decompose product function into sub-function and supply information on that
basis.
 Facilities to convert the value placed on each function into price.
 A value-price conversion table or database.
 A market research toolbox with various forecasting techniques.
 Simulation function (what-if, sensitivity analysis, etc.)

2. Target profit computation support systems

 Support mechanisms for strategy formulation, profit planning, human resource management
and capital investment decision making.
 Product portfolio planning systems, which can calculate the optimal product mix in the future.
 Profit decomposition systems for each product.
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3. Research and development support systems

 Computer graphics, computer aided design (CAD), computer aided engineering (CAE), etc.
At the initial design stage of a product, the considerable space occupied by the drawing
tables of a typical design office has been replaced by computer terminals, and the time taken
to work through an initial engineering drawing-and, more importantly, rework the drawing-has
shortened dramatically as a result of the software currently available.
 Project management system to monitor and aid R&D activities based on expert systems or
artificial intelligence (AL).

4. Research system for infusing target costs into products.

 Value engineering (VE) – in Japan these are based on cost tables reduction databases.
(Cost tables are widely used in Japan and agencies exist to provide relevant data to different
industries. The tables are extremely important and help accurate cost predictions and allow
for a series of ‘what if’ question to be asked.)
 Reduce the Variety in product development .

2. Benefits of Target Costing: (4 Marks)

(i) It reinforces top to bottom commitment towards product and process and aims at identifying
issues to be resolved to achieve competitive advantage.
(ii) It helps to create company’s competitive position– a market oriented management approach.
(iii) Management Control system focuses on cost reduction with value addition.
(iv) It helps to retain or increase market share by aligning the product with customer needs.
(v) It promotes team sprit.

3. Explain the steps involved in target costing approach to pricing. (4marks)

Answer
A brief explanation of the steps involved in target costing approach to pricing is as follows:

(i) Setting of target selling price: The setting of target selling price of product which the customers
are prepared to pay, depends on many factors like: design specifications of the product,
competitive condition, customers’ demand for increased functionality and higher quality
projected production volume, sales forecasts etc. A concern can set its target selling price after
taking into account all of the aforesaid factors..

(ii) Determination of target cost: Target profit margin may be established after taking into account
long-term profit objectives and projected volumes of sales. On deducting target profit margin
from selling price, target cost is determined.

(iii) Estimate the actual cost of the product: Actual cost of the product may be determined after
taking into account the design specifications, material cost and other costs required to produce
the product.

(iv) Comparison of estimated actual cost with target cost: In case the estimated cost of the product
is higher than that of the target cost of the product then the concern should resort to cost
reduction methods involving the use value engineering/value analysis tools.
 92
4. Trace the stages involved in target costing. (4 marks)

Answer
Stage involved in target costing :
Stage 1 : Determine the target price which the customers will be prepared to pay the product.

Stage 2 : Deduct the target profit margin from the target price to determine the target cost.

Stage 3 : Estimate the actual cost of the product.

Stage 4 : If it estimated actual cost exceeds the target cost, investigate the ways of bringing down
the actual cost to target cost

5. Discuss, how target costing may assist a company in controlling costs and pricing of products.
(4 Marks)
Answer
Target costing may assist control of costs and pricing of product as under:

(i) Target costing considers the price that ought to be charged by a company to achieve a given
market share.
(ii) Target costing should take life cycle costs in to consideration.
(iii) If there is a gap between the target cost and expected cost, ways and means of reducing or
eliminating it can be explored.

(iv) The target cost may be used for controlling costs by comparison.

6. List the steps involved in target costing process with the help of a block diagram 6 marks

Solution
Target Costing Process

Set target selling price based on

customer expectations and
sales forecast

Establish profit margin based on

long-term profit objectives and
projected volumes

Determine target (or allowable)

cost per unit (target selling price
less required profit margin)
 93

Compare with Estimate the current

cost of new product

Establish cost reduction

targets for each component
and production activity, using
value engineering and value
analysis

7. What are the benefits of a target costing system? (Marks 3)

Solution
Benefits of Target Costing:
(i) It reinforces top to bottom commitment towards product and process and aims at identifying
issues to be resolved to achieve competitive advantage.
(ii) It helps to create company’s competitive position –a market oriented management approach.
(iii) Management Control system focuses on cost reduction with value addition.
(vi) It helps to retain or increase market share by aligning the product with customer needs.
(vii) It promotes team sprit.

8. State any 5 advantages of “Target Costing”. (4 Marks)

Solution:
Advantages of “Target Costing are as under:
(i)Target costing ensures proper planning well ahead of actual production and marketing.
(ii)Implementation of Target Costing enhances employee awareness and empowerment.
(iii)Foster partnership with suppliers.
(iv) Minimize non value-added activities.
(iv)Encourages selection of lowest cost value added activities.

9. By appropriate presentation show the difference between ‘Target Cost’ AND ‘Traditional Costing’
(4 Marks)
Solution:

Target Costing Traditional Costing

Production Specification Production Specification

Target Price and Volume Product Design

Target Profit Estimated Cost

 94
Target Cost Target Cost

Product Design Target Price

10. Identify the companies, which seem to benefit most from target costing. (4 Marks)

Solution:

Some companies, which seem to benefit most from target costing, are those, which maintain the
following criteria:

(i) Assembly-oriented industries, as opposed to repetitive-process industries that produce

homogeneous products;

(ii)Involved heavily with the diversification of the product lines;

(iii) Use technologies of factory automation, including computer-aided design, flexible

manufacturing systems, office automation, and computer-aided manufacturing;

(iv) Have experienced shorter product life cycles where the pay-back for factory automation
typically must be achieved in less than eight years;

(v) Must develop systems for reducing costs during the planning, design and development stages
of a product’s life cycle;

(vi) Are implementing management methods such as just-in-time, value engineering, and total
quality control

11. Identify Control Points which should be taken care of in all target costing projects. (4 Marks)

Solution:

Control Points which should be taken care of in all target costing projects

(i) Identification of Principal Control Point: Experience shows that there always comes a point,
where the cost of maintaining the design team exceeds the savings gardened from additional
iterations. It is also necessary that most products should be launched within a reasonably short
time or they will miss the appropriate market, where they will beat the delivery of competing
products to the market. This emphasis that the principal control points over the course of target
costing programme should be properly taken care of.

(ii) Point of Go / No Go Decision: If target costing is not reached, management retains power to
abandon the design project. There comes a point, when actual performance is very close to
expected performance in matter of cost incurrence.

(ii) Milestone can be in terms of Timer of Points: A milestone can be in terms of time, say one
month. It can also be on the points in design process, at which specific activities are
completed.
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Just–In-Time (JIT)
1. Idea of modern inventory & production management as compare to the traditional concept
Just –in-time(JIT) production (also called lean production) is a “ demand- pull” manufacturing
system in which each component in a production line is produced immediately as need in which by
the next step in the production line. In a JIT production line, manufacturing activity at any particular
workstation is promoted by the need for that station’s output at the following station. Demand
triggers each step of the production process, starting with customer demand for a finished product at
the end of the process and working all the way back to the demand for direct materials at the
beginning of the process. In this way, demand pulls and order through the production line.
The demand-pull features of JIT production systems, achieve close coordination among
workstations. It smoothes the flow of goods, despite low quantities of inventory. JIT production
systems aim to simultaneously
(1) meet customer demand in a timely way
(2) with high-quality products and
(3) at the lowest possible total cost.
Companies implementing JIT production systems manage inventories by eliminating (or least
minimizing ) them. There are five main features in a JIT production system :

 Organize production in manufacturing cells, a grouping of all the different types of equipment
used to make a given product. Materials move from one machine to another where various
operations are performed in sequence. Materials—handling costs are minimized.
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 Hire and retain workers who are multi-skilled so that they are capable of performing a verity of
operations and task. These tasks include minor repairs and routine maintenance of equipment.
This training adds greatly to the flexibility of the plant.

 Aggressive pursue total quality management (TQM) to eliminate defects. Because of the tight
links stages in the production line, and the minimum inventories at each stage, defect arising at
one stage quickly affect other stages. JIT creates an urgency for solving problems immediately
and eliminating the root cause of defects as quickly as possible.

 Place emphasis on reducing setup time. Reducing setup time makes production in smaller
batches economical which in turn reduce inventory levels. Reducing manufacturing lead time
enables a company to respond faster to changes in customer demand.

 Carefully selected suppliers who are capable of delivering quality materials in a timely manner.
High-quality goods and make frequent deliveries of the exact quantities specified on a timely
basis. Suppliers often deliver materials directly to the shop floor to be immediately placed into
production.

2. Features:: (3 marks)
a) Low or Zero inventories; emphasis on operation from source to customer .
b) Emphasis on customer service and timing.
c) Short of operations. d) Flexibility of operations.
e) Efficient flow f) Use of kanban and Visibility.

3. Benefits:: (4 marka)
a. Reduce inventories and WIP b. Reduce space requirements, set up
time
c. Shorter throughput times d. Smooth work force
e. Greater productivity f. Greater employees involvement, participation, motivation
g. Improved product quality h. Improved customer service and smaller batch size.
i. More uniform loading of facilities.
4. Pre –requisites of JIT: (2 marks)
(i) Low variety (ii) Demand stability
(iii) Vendor reliability (iv) Defect free materials.
(v) Good communication (vi) Preventive maintenance
(vii) Total quality control.

5. Desirable factor of JIT: (2 marks)

(i) Management commitment (ii) Employee investment. (iii) Employee
flexibility.

6. Effect of using JIT (Just in Time) in Inventory Control. (3 marks)

i. saves cost due to lead time
ii. saves cost due to holding inventory like insurance, spoilage, obsolescence etc.
iii. does away with locking up of funds in inventory
iv. helps very much in working capital management

7. JIT as a tool to improve organisation’s profitability. (3 marks)

i) Immediate detection of defective goods being manufactured so that early correction is ensured
with least scrapping.
ii) Eliminates/ reduces WIP between machines within working cell.
iii) Overhead costs in the form of rent, storing , insurance, maintenance costs etc. are reduced.
iv) Higher product quality ensured by the JIT approach leads to higher & premium selling price.
v) Detection of problem areas due to better production/scrap reporting/labour tracing and
inventory accuracy lead to reduction in costs by improvement.
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8. JIT system and overhead costs: (3 marks)

(i) Reduction in material handling, facilities and quality inspection costs;
(ii) Reduction inventory reduces storage costs.
(iii) Costs shift from overhead cost pool to direct costs when machine cells are introduced. A more
reliable allocation of costs to products and therefore more accurate analysis for decision
making.
(iv) With the JIT system in place, the general overhead pool can be better allocated due to
availability of more information regarding the most appropriate cost drivers.

9. Basic Steps for implementing lean/JIT production: (4 marks)

The following are the basic steps to implement Lean/JIT Production:
i. Re-engineer the manufacturing system
ii. Reduce set-ups
iii. Integrate quality control
iv. Integrate preventive maintenance
v. Level and balance the system
vi. Integrate a pull system
vii. Control inventory
viii. Implement a vendor program
ix. Utilize computer integrated manufacturing benefits

10. Explain, how JIT eliminate wastage of resources. (4 marks)

Answer

JIT helps in reducing waste of time; thereby the entire production process is concentrated on the
time spent in actually producing products. For example, all inspection time is eliminated from the
system as operators conduct their own quality checks.
Secondly, all movement, which involves shifting inventory and work-in-process throughout various
parts of the plant, can be eliminated by clustering machines together in logical groupings.

Third, queue time is eliminated by not allowing inventory to build up in front of machine.

Finally, one can eliminate storage time by clearing out excessive stocks of inventory and having
suppliers deliver parts only as and when needed.

Another way in which waste may be eliminated in a JIT system is to charge cost drivers to wasteful
activities that accumulate costs. By shrinking the amount of wastage of time out of the
manufacturing process, a company effectively eliminates activities that do not contribute to the value
of a product, which in turn reduces the costs associated with them.

11. How does the JIT approach help in improving an organisation’s profitability? (Marks 4)

Solution
JIT approach helps in the reduction of costs/increase in prices as follows:
i) Immediate detection of defective goods being manufactured so that early correction is ensured
with least scrapping.
ii) Eliminates/ reduces WIP between machines within working cell.
iii) OH costs in the form of rentals for inventory, insurance, maintenance costs etc. are reduced.
iv) Higher product quality ensured by the JIT approach leads to higher premium in the selling
price.
v) Detection of problem areas due to better production/scrap reporting/labour tracing and
inventory accuracy lead to reduction in costs by improvement.
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12. Explain, how the implementation of JIT approach to manufacturing can be a major source of
competitive advantage.

Answer
JIT provides competitive advantage in the following ways:

(i) Stocks of raw materials and finished goods are eliminated, stock holding costs are avoided.
(ii) JIT aims at elimination of non-value added activities and elimination of cost in this direction will
improve competitive advantage.
(iii) It affords flexibility to customer requirements where the company can manufacture customized
products and the competitive advantage is thereby improved.
(iv) It focuses the direction of performance based production of high quality product. (v) It minimize
waiting times and transportation costs.

13. Explain the concept of Just In time approach in a production process. (4 Marks)

Answer
Just in Time in Production Process
1. Products, Spare parts / materials are received directly at production floor. Inspection is
completed before delivery of materials.
2. Setup time is minimized while also reducing long production runs. There by eliminating
defectives, scrap and product obsolescence.
3. Work-in-progress is reduced by use of kanban card or working cells or both.
4. Workers are trained on a variety of machines, allowed to stop machines when they identify a
problem, fix it or call the repair team and adequately compensated.
5. Supporting systems such as administration, accounting and cost reporting are suitably
modified to shift from the conventional mode to the improved JIT requirements.

14. The following independent situations are given is JIT systems of production. You are required to
state if each recommendation is valid or invalid and give a brief reason.

SL. Situation Recommendation by the Cost Accountant

No.
A company produces LCD TVs. Compute inventory turnover every month. Break it down
Presently total inventory into raw material, WIP, expensive inventory and
turnover is measured finished goods.
annually.
Textile company. Accept employees’ claim for piece rate inventive for
exceeding a certain production volume.
Sports goods manufacturing Closely monitor direct labour variances including idle
company time variances to convince employees to work
faster.
(iv) Multiproduct production Monitor the average set up time per machine in a period
which is given by
Aggregate set up time of all machines
Total number of machines.
(4 Marks)

Answer

Situation Valid / Invalid

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A company produces Valid - JIT system emphasize extraordinary high inventory
LCD TVs. Presently turnover. When a company is producing LCD TVs, total
total inventory turnover of inventory will be high, when the
turnover is recommendation of computing of inventory turnover and
measured annually. breaking It into raw material, W-I-P and finished goods is
given JIT system is very much valid.
Textile company. Invalid - In textile industry, employees are paid extra if they
exceed certain production volume targets. JIT focuses on
producing inventory on account of high incentives. So any
piece rate system must be eliminated and replaced with
measures that focus on the quality of output.
Sports goods Invalid - Monitoring Direct labour efficiency is highly
manufacturing inappropriate in JIT system. As JIT system unlike
company. traditional system does not focus on fast workings of
employees. Instead JIT focuses on quality of product
manufactured.
(iv) Multiproduct production. Invalid - The average setup time per machine is of great
importance as it can be measured periodically and plotted
on a trend line. The shortest possible setup intervals are
crucial for the success of short production runs, so this is a
major JIT measurement. It is best to measure it by
machine, rather than in the aggregate, since an aggregate
measure does not reveal enough information about which
equipments requires more setup time reduction work.

15. How to reduce excessive work-in-process inventory and defective parts in JIT System?

Solution:

There are two ways to reduce excessive work-in-process inventory and defective parts in JIT
System.

(i) Prepare ‘Kanban’ which notify the downstream machine to supply required parts, authorizing
the production of just enough good components to fulfill the production requirements. As a
result defects are identified at the time of manufacturing. With this approach WIP inventory
cannot build up in the production system, since WIP is produced to fulfill the requirement of
next process with zero time gap.

(ii) Set up of Manufacturing or working cells. A working cell is a small cluster of machines which is
run by a single machine operator. This individual machine operator takes each output part from
one machine to another within the cell. So, there is no way for WIP to build up between
machines.

The operator can immediately identify defective output. This is the additional benefit of lower
maintenance costs since the smaller machines used in a machine cell.

16. Backflush accounting (4 marks)

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JIT is an entirely different system comparing to traditional system. It requires its own cost accounting
system. The absence of stocks makes choices about stock valuation systems unnecessary and the
rapid conversion of direct material into cost of goods sold simplifies the cost accounting system. The
approach is known as Backflush accounting.

Backflush accounting delays the recording of costs until after the events have taken place, then
standard costs are used to work backwards to ‘flush’ out the manufacturing costs. There are two
events that trigger the records kept in most backflush accounting systems:

 The first is the purchase of raw materials, In a true JIT system where absolutely no raw material
stock is held, even this trigger is not relevant and raw materials are ‘flushed’ when the second
trigger is activated.

 The second trigger is either the transfer of goods to finished goods stock or, in a true JIT
system, the sale of goods.

This is the system used by Toyota in its UK factory. In true Japanese style it manipulates employees
to behave in a certain way.

1. Employees must concentrate on achieving sales because cost of sales

is the trigger  nothing gets recorded until the sale is made.
2. Second there is no benefit in producing goods for stock

The Backflush accounting model cannot be used by all organisations. It can only be used where a
JIT-type system is in operation. Where it is used it does have advantages. The traditional system is
time consuming and expensive to operate, as it requires a considerable amount of documentation,
such as material requisitions and time sheets to support it in order to maintain the WIP records and
job cards. If a company operates with low stock levels, the benefits of operating the traditional
costing. system are few. By introducing a Backflush system a considerable amount of clerical time is
saved.

In Backflush accounting, direct labour is not in cost category. Instead labour is treated as an indirect
cost and is included in conversion cost with the overheads. This is because production is only
required when demand requires it and so production labour will be paid regardless of activity. All
indirect costs are treated as a fixed period expense.

Backflush accounting can be criticised because of the lack of information that it provides. Some
argue, quite rightly, that in reality it is impossible to eliminate all stock as a truck arriving with raw
material creates stock until it is moved to and used in production. If Backflush accounting is used in a
system where a substantial amount of stock is held, a physical stock-take will be needed, because
the system does not record the quantity of stock. Instead it is derived on paper by the difference
between the standard cost of material in the goods sold and the amount of materials purchased. This
must be checked by a physical stock-take from time to time. Journals are prepared following the
principle of integrated accounting as under absorption costing.

17. Explain briefly the problems with back flushing that must be corrected before it will work properly.
(Marks 4)
Answer
The problems with back flushing that must be corrected before it works properly are:

(i) Production reporting :The total production quantity entered into the system must be absolutely
correct, if not, then wrong components and quantities will be subtracted from the stock.

(ii) Scrap reporting : Abnormal scrap must be diligently tracked and recorded. Otherwise materials
will fall outside the back flushing system and will not be charged to inventory.
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(iii) Lot tracing : it is impossible under the back flushing system. This is required when a
manufacturer needs to keep records of which production lots were used to create a product is
case all the items in a lot need be recalled.

(iv) inventory accuracy : : maintain accurate set of inventory records.

Materials Requirement Planning (MRP) System

Materials requirements planning (MRP) is a “pull-through” system that manufactures finished goods
for inventory on the basis of demand forecasts.

1. MRP uses: (4 marks)

(1) demand forecasts for the final products;

(2) a bill of materials outlining the materials, components, and subassemblies for each final
product and ;
(3) the quantities of materials, components , finished products, and product inventories to
predetermine the necessary outputs at each stage of production.
Taking into account the lead time required to purchase materials and to manufacture components
and finished product, a master production scheduled specific the quantity and timing of each item to
be produced.

2. Requirements for operation of a MRP system (3 marks)

(i) Master production schedule : It specifies the quantity of each finished unit of products to be
produced along with the time at which each unit will be required.
(i) Bill of materials file : This file specifies the sub-assemblies, components and materials
requirement for each item of finished goods.
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(ii) Inventory file : It maintains details of items in hand for each sub-assemblies, components
and materials required.
(iii) Routing file : This file specifies the sequence of operations required to manufacture
components sub-materials required.
(v) Master parts file : It contains information about the production time of sub-assemblies and
components produced internally and lead time for externally procured items.

3. Objectives of MRP : (4 marks)

-- It determines the quantity and timing of finished goods demanded.

-- It determines time phased requirements of the demand for materials, components and sub
assemblies over a specified planning time horizon.
-- It computes the inventories, w.i.p batch sizes and manufacturing and packing lead times.
-- It controls inventory by ordering components and materials in relation to orders revived rather
than ordering them from stock level point of view.

4. “Optimum level of inventory is that which minimises the total costs”. Discuss. (4 marks)

Answer
It is true that the optimum level of inventory is that which minimises the total costs. Inventories entail
two types of relevant costs – (i) cost of carrying inventory and (ii) cost of ordering. Both the costs are
conflicting as that if the firm decides to have huge stock, the costs of carrying will increase and the
costs of ordering will fall and vice versa. Therefore, these costs have to be balanced. Two key
questions to have optimum level of inventory are: (i) What quantity should be purchased or
manufactured. (ii) when should that quantity be purchased or manufactured.

If EOQ and safety stock are well balanced that will minimise the total costs.

5. Mention few areas of material cost control. (4 marks)

Answer

The potential areas for materials cost control may be considered under the following heads :

Purchasing : Before purchasing various type of materials it is necessary to determine: What to

purchase ? When to purchase ? How much to purchase ? From where to purchase ? At what price
to purchase ? The price paid should be the minimum possible.

Stock control : Its objective is to achieve maximum efficiency in production and sales with minimum
investment in inventory. This objective may be achieved by resorting to inventory control techniques.

Materials storage, issue and handling : There should be no overstocking of materials in order to
minimize interest charges; godown charges, deterioration in quality and losses due to obsolescence.

Issues of materials should be made on the basis of properly authorized requisition slips; usually it is
the foreman of a department who has the authority to draws materials from the store. Issue must be
made on the basis of FIFO method.

Material should be handled properly in the store. Proper tools and equipment should be used for
handling them so as to reduce wastage and losses. Mishandling of materials in stores will result in
the increase of costs.
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Wastage : It should be minimum during the process of manufacture.

6. Mention the data required to operate the material requirement planning system. (4 marks)

Solution

Data requirements to operate material requirement planning system:

1. The master production schedule: This schedule specifies the quantity of each finished unit of
products to be produced and the time at which each unit will be required.

2. The Bill of material file: The bill of material file specifies the sub-assemblies, components and
materials required for each of the finished goods.

3. The inventory file: This file maintains details of items in hand for each sub-assembly,
components and materials required for each of the finished goods.

4. The routing file: This file specifies the sequence of operations required to manufacture sub-
assemblies, components and finished goods.

5. The master parts file: This file contains information on the production time of sub assembles;
components produced internally and lead times for externally acquired items.

7. Explain the pre-requisites for successful operation of material requirement planning. (5 Marks)

Answer
Pre-requisites for successful operation of MRP system are:

(i) The latest production and purchasing schedules prepared should be strictly adhered to Day
to Day change from predetermined schedules will cause chaos.

(ii) Raw Materials, sub-assemblies and components required for production should be pre-
determined in quantifiable terms. Standard should be set for the consumption quantity,
quality, mix and yield of raw materials for every unit of finished product.

(iii) Work-force must be appraised of the system and the need for absolute adherence to the
schedules prepared.

(iv) Necessary internal control system should be developed to ensure total adherence to the
schedule.
(v) Accuracy of the data supplied is vital to the MRP system.

8. Write a note on “Requirements Explosion”.

Solution:
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The MRP system decides the demand for materials, components and sub assemblies at each stage
of production. Once the scheduled production starts, the output of each department is pushed
through the MRP system to the next department.

From the data input, the MRP system knows:

(i) What it is expected to produce (through the MPS file)?

(ii) How it should produce it (through the BOM file)? and with
(iii) What it has to produce it (through the inventory records file)?

This programme starts with the finished goods demand (from the MRPs) and converts the demand
requirements backward in time to schedule the desired production of the finished goods from raw
materials and component parts with ‘time phased’ adjustments for lead time requirements. This
process is called ‘Requirements Explosion’.

Enterprise Resource Planning (ERP)

Enterprise resource planning software or ERP attempts to integrate all departments and functions
across a company into a single computer system that can serve all those different departments
particular needs. In fact ERP combines all computerised departments together with the help of a
single integrate software program that runs off a single database so that various department can
more easily share information and communicate with each other.

1. The need for ERP: (4 marks)

Most organisation across the world have realised that in a rapidly changing environment, it is
impossible to creates and maintain customer designed software package which will cater to all their
requirements and be up-to-date. Realising the requirement of user organisations, some of the
leading software companies have designed Enterprise Resource Planning software, which offers an
integrated software solution to all the function of an organisation.

2. Components of ERP : (4 marks)

To enable the easy handling of the system, ERP has been divided the following core subsystems,
1. sales and marketing, 2. master scheduling,
3. materials requirements planning, 4. capacity requirement planning,
5. bill of materials, 6. purchasing,
7. shop floor control, 8. accounts payable/receivable ,
9. logistic, 10. assets management and
11. financial accounting.

3. Features of ERP: (4 marks)

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 ERP facilities company-wide Integrated Information System covering all functional areas like
manufacturing, selling and distribution, payables, receivables, inventory, accounts, human
resources, purchases etc.
 ERP perform core activities and increases customers service, thereby augmenting the corporate
image.
 ERP bridge the information gap across organisations.
 ERP provides complete integration of system not only across departments but also across
companies under the same management ;
 ERP is the solution for better project management.
 ERP allows automatic introduction of the latest technologies like Electronic Fund Transfer (EFT).
Electronic Data Interchange (EDI), Internet, Intranet, Video conferencing, E—commerce etc.
 ERP eliminates most business problems like materials shortages, productivity enhancements,
customer service, cash management, inventory problems, quality problems, prompt delivery etc.
 ERP not only addresses the current requirement of the company but also provide the opportunity
of continually improving and refining business Processes.
 ERP provides business intelligence tools like Decision Support Systems (DSS), Executive
Information System (EIS), Reporting. Data Mining and Early warning systems (Robots) for
enabling people to make better decisions and thus improve their business processes.

4. Benefits of ERP (4 marks)

1. Product Costing: Determination of cost of products correctly, is quite critical every industry.
ERP supports advances costing methods, including standard costing, actual costing and
activity–based costing. Additionally, all costing methods and information can be fully integrated
with finance.
2. Inventory Management: ERP can be used in multi-national, multi-company, and multi-site
manufacturing and distribution environments. This system simplifies complicated logistics by
allowing one to plan and manage companies in different countries as a single unit and its
advanced functionality allows one to process product and financial information flows in several
different ways.
3. Distribution & Delivery: Flexibly & efficiently to deliver the right product from the right warehouse
to the right customer at the right time. To the customer, the most important element is quality of
one-time delivery. It doesn’t matter how well a product is made if arrives late.

4. E-Commerce : Internet enables ERP to act efficiently (Case Study : Wal-Mart) ,

5. Automatic Control : It ensure automatic quality control procedure.
6. Sales Service : It ensures better after sales service.
7. Improvement in Production Planning : It improved production planning.
8. Quick response: It enables quick response to change in business operations & market
conditions.
9. Cumulative Edge’s: It helps to achieve competitive advantages by improving business process.

5. Reasons for implementation of ERP (6 marks)

1. Improve a company business performance:

ERP automates the tasks involved in performance a business process – such as order
fulfillment which involves taking an order from a customer, shipping it and billing for it.

2. Standardize manufacturing processes :

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Manufacturing companies --- especially those with an appetite for mergers and acquisitions
--- often find that multiple business units across the company make the same widget using
different methods and computer systems,
3. Integrate Financial data:
As the CEO tries to understand the company’s overall performance, he or she may find
many different versions of the truth. Finance has its own set of revenue numbers, sales has
another version, & the different business units may each have their own versions of how
much they contributed to revenues.
ERP creates a single version of the truth that can’t be questioned because everyone is using
the same system.
4. To standardise HR information:
Especially in companies with multiple business units, HR may not have a unified, simple
method for tracking employee time and communicating with them about benefits and
services. ERP can fix that.

Service Sector
1. The application of Service Costing:
Service costing can be applied to service provided to customers outside the organisation, for
example, the services supplied by transport operations, hospitals and hotels.
It can also be applied to internal services and functions which do work for other departments within
the same organisation. For example, service costing can be applied to the services supplied by the
canteen, the maintenance department and the personal function.

The unique characteristic features in performance measurement in service sector are:

(i) Most services are intangible.

(ii) Service outputs vary from day to day.
(iii) The production and consumption of many services are inseparable.
(iv) Services are perishable and cannot be stored.

2. Explain the main characteristics of Service sector costing. (5 Marks)

Answer
Main characteristics of service sector are as below:

(a) Activities are labour intensive: The activities of service sector generally are labour intensive.
The direct material cost is either small or non-existent.
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(b) Cost-unit is usually difficult to define: The selection of cost units usually, for service sector is
difficult to ascertain as compared to the selection of cost unit for manufacturing sector. The
following table provides some examples of the cost units for service sector.

External Customers Cost unit

(i) Hotel : room occupancy or room-night.

(ii) Hospital : in patient-day, bed occupancy.
(iii) Haulage contractor : ton-Kilometer (Absolute or commercial)
(iv) Passenger transport : Passenger Kilometer (public) or distance (Taxi)
(v) Power house : Kilo watt hour (KWH or MWH)
(vi) Educational institute : No. of students
Internal Services Cost unit
1. Staff canteen : Meals provided, no. of staff
2. Machine maintenance : maintenance hours provided to user department
3. Computer department : computer time provided to user department
4. Own power supply : cost per unit of service ( KWH)

(c) Product costs in service sector: Costs are classified as product or period costs in
manufacturing sector for various reasons viz.

- To determine the unit manufacturing costs so that inventories can be valued and the
selling price be determined & verified.
- T o report production costs on income statement.
- To analyse costs for control purposes.

The only difference between manufacturing and service sector is that in service sector there is
no physical product that can be stored, assembled and valued.

3. The instantaneous & perishable nature of services: (3 marks)

Many services are provided instantaneously rather than for inventory (stock); for example, a
restaurant meal is cooked as it is ordered by the customer. This brings with it particular management
problems of planning and control but it does mean that the incidence of WIP is very low, that is, it is
rarely necessary to value part-finished units of service at the end of an accounting period.
Many services also ‘perish’ immediately; for example, if a cinema seat is vacant when a film is
showing it cannot be stored in inventory (stock) for a later sale. The opportunity to gain revenue from
that seat at that particular showing of the film has been lost forever. Therefore, capacity utilization
becomes a very important issue for managers in many service organisation.

4. Pricing by service sector ( 3 marks)

The service provided by service sector has no physical existence, a value is to be fixed and billed for
its clients. Most of the service organizations use a form consisting of time and material pricing to
arrive at the price of a service.
Service companies such as appliance repair shops, automobile repair business, calculate their prices
by using two computations, one for labour and other for materials and parts. A mark-up percentage
may also be added to the cost of labour, materials and parts to arrive at the price to be billed. For
professionals, direct labour costs and apportioned overhead and indirect costs are considered for
pricing.

5. Problem for adoption of ABC system in service organization – (3 marks)

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(i) Facility sustaining costs (such as property, rents etc.) represent a significant portion of total
costs and may only be avoidable if the organization ceases business. It may be impossible to
establish appropriate cost drivers.
(ii) It is often difficult to define products where they are of intangible nature. Cost objects can
therefore be difficult to specify.
(iii) Many service organizations have not previously had a costing system and much of the
information required to set up a ABC system will be non-existent. Therefore introduction of ABC
may be expensive.

6. Customer Costing (4 marks)

Customer costing analyses the costs incurred to earn the revenues from customers. A customer cost
hierarchy, categorizing the costs relating to the customers into different cost pools on the basis of
different types of cost drivers or different degrees of difficulty in determining cause and effect
relationship, is used.
It can be introduced in a company engaged in courier service where the costs to serve the
customers vary with the type of service selected by customers
a. how fast the package is to be delivered,
b. the destination, weight, size of package and
c. whether the package is to be collected from customers’ location or will be
dropped at the office of the courier firm.
Consider a banking sector. A bank’s activities for customer will include the following types of
activities. These are:
(a) Stopping a cheque (b) Withdrawal of cash
(c) Up-dating of pass book (d) Issue of duplicate pass book
(e) Returning a cheque because of insufficient funds
(f) Clearing of a customer cheque
Different customers or categories of customers use different amount of these activities and so
customer profiles can be built up and customer can be charged according to the cost to serve them.
These parameters can be used with the objective of determining customer profitability and based on
the costs involved in handling each customer, the firm can even offer volume discounts to customers
who use the services heavily.

7. Discuss with examples, the basic costing methods to assign costs to services. (Marks 3)

Solution
(i) Job costing method: The cost of a particular service is obtained by assigning costs to a distinct
identifiable service.

e.g. Job Costing method is used in Service Sectors- like Accounting Firm, Advertisement
campaign.

(ii) Process Costing Method: Cost of a service is obtained by assigning costs to masses of similar
unit and then computing cost/ unit on an average basis. E.g. Retail banking, postal delivery,
credit card etc.

(iii) Hybrid Method or Multiple Costing: Combination of both (i) & (ii) above.

8. “Customer profile is important in charging cost,” Explain this statement in the light of customer
costing in service sector. (4 marks)

Solution
Answer of the first part is same as in “Customer costing in the service sector”:
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Customer profile is important in analyzing cost under the following categories.

1. Customer specific costs: These are the direct and indirect cost of providing service to
customer plus customer related cost assigned to each customer. For example: Cost of
express courier service to a client who requests over night delivery of some agreement.

2. Customer-line categories: These are the costs which are broken into broad categories of
customers and not individual customers.

3. Company Costs: These are those costs which are not allocated to either customer line or
individual customers but charge to company. The example is the cost of advertisement to
promote sales of service.

Total Quality Management (TQM)

TQM may be defined as the continues improvement in quality, productivity & effectiveness obtained
by establishing responsibility for process as well as output. TQM is a philosophy & a movement
rather than a body of technique. There are many alternative models & definitions of TQM.

Quality is a measure of goodness to understand how a product meets its specifications. ISO
standard defines quality as “the totality of features and characteristics of a product or service that
bears its ability to satisfy stated or implied needs.”

Quality has nine important dimensions demonstrated in the table below.

Dimension Meaning and Example

Performance Primary product characteristic, such as the brightness of the picture
Features Secondary characteristic, added features, such as remote control
Conformance Meeting specifications or industry standards, workmanship
Reliability Consistency of performance over time, average time for the unit to fail
Durability Useful life, includes repair
Service Resolution of problems and complaints, ease of repair
Response Human-to-human interface, such as the courtesy of the dealer
Aesthetics Sensory characteristics, such as exterior finish
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Reputation Past performance and other intangibles, such as being ranked first

1. Definition of Quality: ( Definitions changes from Seller’s market to Buyer’s market )

1. The first definition given was quality is conforming to specifications. Generally the
specifications are set by the producers.

2. The Second definition given for quality was fitness for use. A product which is usable and
conforms to all the specifications given, will generally be a good product. But a good product,
which is not saleable, will not be appreciated. To sell a product it is necessary to incorporate
customers, viewpoint. A customer will buy a product only if the cost, reliability, aesthetics, etc.
suit his conditions. Hence customer focus has to be given prime importance and even in
defining the quality, customer focus has to be stressed.

3. The third definition given for quality was customer satisfaction. A product, which satisfies
the customer, will have a great market. The customer will also be happy that the product of
his choice is being given to him. A person will be satisfied if all his needs are fulfilled. The
following factors are the commonly expressed “satisfaction” of the Customer:
(i) Utility value (ii) Affordable cost
(iii) Longer life (iv) Reliable performance
(v) Product look (vi) Ease of maintenance
(vii) Prompt after sales service, etc.

4. The fourth definition given to quality was delighting the Customer. Delightment is one step
ahead of satisfaction. A delighted customer is definitely in a different, better planed as
compared to a satisfied customer. When the product fulfils both the expressed and
unexpressed, i.e., explicit and implicit needs of the customers, he is delighted.

The industries decided that they should work towards delighting the customer by providing
them the products which will fulfill both their expressed and unexpressed needs. Such a
status will ensure good business and help in producing quality goods.

2. Core Concept of TQM:

(a) Quality Control (QC): It is concerned with the past, and deals with data obtained from
previous production, which allow action to be taken to stop the production of defective
units.
(b) Quality Assurance (QA): It deals with the present, and concerns the putting in place of
systems to prevent defects from occurring.
(c) Quality Management (QM): It is concerned with the future, and manages people in a
process of continuous improvement to the products and services offered by the
organization.

3. PRAISE: various stages/ steps: (marks 3)

Stage Description
1 Identification of customers /customer groups
2 Identification of customer expectations
3 Identification of customer decision – making requirements & product utilities.
4 Identification of perceived problems in decision making process & product
utilities.
5 Comparison with other organizations and Benchmarking
6 Customer Feedback
7 Identification of improvement opportunities
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8 Quality improvement process through (a) New Strategies; (b) Elimination of
deficiencies; and (c) Identifying solutions.

4. PRAISE Analysis. (marks 4)

Step Activity Elements

1 Problem identification * Areas of customer dissatisfaction

* Absence of competitive advantage
2 Ranking * Prioritise problems and opportunities by
1. Perceived importance, and
2. Ease of measurement and solution
3 Analysis * Ask “Why?” to identify possible causes. Keep
Asking “Why?” to move beyond the symptoms &
To avoid jumping to premature conclusions.
* Ask ‘What?’ to consider potential implications
* Ask ‘How much?’ to quantity cause and effect
4 Innovation * Use creative thinking to generate potential solutions
* Operationalise these solutions by identifying
1. Barriers to implementation,
2. Available enablers, and
3. People whose co – operation must be sought
5 Solution * Implement the preferred solution
* Take appropriate action to bring about the required
changes
* Reinforce with training and documentation back – up
6 Evaluation * Monitor the effectiveness of actions
* Establish and interpret performance indicators to
track progress towards objectives
* Identify the potential for further improvements and
return to step 1

5. List out the remedies available for difficulties experienced during implementation of PRAISE.
(marks 4)
Solution:

Remedies available for difficulties experienced in each step available during implementation of praise:

Step Activity Remedies

Problem Identification  Participative approaches like brainstorming, multi-voting, panel
discussion.
 Quantification and precise definition of problem.
Ranking  Participative approach.
 Subordination of individual to group interest.
Analysis  Lateral thinking brainstorming.
(iv) Innovation  Systematic evaluation of all aspects of each strategy.
Solution  Effective internal communication.
 Training of personnel and managers.
 Participative approach.
(vi) Evaluation  Effective control system to track actual feedback system.

6. Fundamental requirements for the implementation of TQM process or 6 C’s: (marks 4)

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1. Commitment: if a TQM culture is to be developed, total commitment must come from top
management. It is not sufficient to delegate ‘quality’ issues to a single person. Quality
expectations must be made clear by the top management, together with the support and
training required for its achievement.
2. Culture: Training lies at the centre of effecting a change in culture and attitudes. Negative
perceptions must be changed to encourage individual contributions and to make ‘quality a
normal part of everyone’ job.
3. Continuous Improvement: TQM should be recognized as a ‘continuous process’. It is not a ‘one-
time programme’. There will always be room for improvement, however small.
4. Co-operation: TQM visualizes Total Employee Involvement (TEI). Employee involvement and
cooperation should be sought in the development of improvement strategies and associated
performance measures.
5. Customer focus: The needs of external customers (in receipts of the final product or service)
and also the internal customers (colleagues who receive and supply goods, services or
information), should be the prime focus.
6. Control: Documentation, procedures and awareness of current best practice are essential if
TQM implementations are to function appropriately. Useless control procedures are in place,
improvements cannot be monitored and measured nor deficiencies corrected.

7. Control in the TQM process. (marks 4)

a. Process definition: The definition of the process, inputs and outputs gives a framework for the
writing of procedures and standard methods and also provides a focus for improvement
opportunities. The clear definition and documentation of procedures facilitates job flexibility,
makes control easier and increases the level of productivity.
b Database: Documentation of key data on processes in an important step in TQM. By charting
processes for each activity, establishing time barriers, constraints, priorities, degrees of difficulty
and expected improvement times, a critical database is established.
c. Quality Manual: If defines the basic philosophy of the organization, the structure and
responsibilities of managers and departments and the relationship between them. It also
contains the methods to be used to ensure quality, including the composition of teams, and the
audit procedures to be adopted.
d. Improved decision-making: By providing a sound control environment, which supports business
decisions with appropriate measurement and analysis, the controllership function pursues
complete customer satisfaction.
e. Control and Continuous improvement: TQM facilitates not only control, but also continuous
improvement. The monitoring of data around a process will allow modifications which make it
in-control and capable. As changes or improvements are made they are documented and the
system updated so that everyone uses the current best method.
f. Use of Control reports: Diagrams, statistical quality control charts and cost of quality reports are
prepared for periodic review of the TQM system in operation. The deviation from expected
costs are analyzed for suitable corrective action.

8. List a few principles of TQM (marks 4)

1. Clear exposition of the benefits of a project.
2. Total Employee involvement (TEI).
3. Process measurement.
4. Involvement of all customers and contributors.
5. Elimination of irrelevant data.
6. Understanding the needs of the whole process.
7. Use of graphical and pictorial techniques to achieve understanding.
8. Establishment of performance specifications and targets.
9. Use of errors to prompt continuous improvement.
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10. Use of statistics to tell people how well they are doing.

9. TQM : Disoriented & Misdirected & correction: (marks 4)

TQM may become misdirected on the following grounds –

1. Focus on documentation of process and ill – measurable outcomes;
2. Emphasis on quality assurance rather than improvement; and
3. Internal focus which is at odds with the alleged customer orientation.
This can be corrected by reviving the customer focus with Total Employee Involvement (TEI),
oriented towards organizational goals. This will involve the following areas of thrust –
1. Loyalty to the vision of the company through the pursuit of tough, visible goals
2. Recognition of satisfied customers and motivated employees as the true assets of a company
3. Delegation of decision – making to the point of responsibility by eliminating hierarchical tiers of
authority to allow direct and speedy response to customer needs.
4. Decentralization of management to make best use of the creative energy of the workforce

10. Critical success factors of TQM: (marks 4)

 Focus on customer needs.
 Everyone in the organization should be involved.
 Focus on continuous improvement.
 Design quality in product and production process.
 Effective performance measurement system.
 Rewards and performance measurements should be renewed.
 Appropriate training and education to everyone to understand the aim of TQM.

11. Six Sigma (6) (marks 4)

Continuous improvement can be brought in to the organizational culture by introducing continuously
changing, planned targets. One such target can be six sigma accuracy. The Sigma accuracy means
the process is 99.999998% accurate. That is the process will/can produce only 0.002 defects per
million. This is the structural meaning of six sigma. However in quality practice 6 means 3.4 parts
per million ( PPM ).

Six sigma is a statistical measure used to ensure quality of products and services. The six sigma
academy has developed a break through strategy consisting of measure, analyze, improve and
control, that allows companies to make exceptional bottom-line improvements.

In addition to the material and labour savings, which flow directly to the bottom line, a company
engaged in six sigma can expect to see:
1. Improved customer satisfaction 2. Reduction cycle time
3. Increased productivity 4. Reduction in total defect
5. Improved process flow

Sigma Parts per million

6 3.4 defects per million
5 233 defects per million
4 6,210 defects per million
3 66,807 defects per million
2 3,08,537 defects per million
1 6,90,000 defects per million
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In a six Sigma organization employees assess their job functions with respect to how they improve
the organization.

12. Cost of quality (marks 4)

Prevention Costs: Design engineering, Process engineering, Supplier evaluations, Preventive

equipment maintenance, Quality training, Testing of new materials , O.H.S.M.
Quality Engineering, Quality Audits programme, Design Review, Quality
Circles etc

Appraisal Costs: Inspection of material , w.i.p. & online products, Manufacturing and process
inspection, Product testing, Quality audits for going process , Costs of field
tests, Costs of technicians. losses during production. Loss of material in store.
Inspection, Product Acceptance, primary Packaging, Continuing Supplier
Verification etc

Internal Failure cost: Spoilage, Rework, Scrap, Machine repairs, Manufacturing/process engineering
on internal failures, Canning cost-- Light weight, low cost but shock proof.
Scrap, Re-Inspection, Re- Testing, etc

External failure cost: Customer Support feed-back, Manufacturing/ process engineering for external
failures, Warranty repair costs, Liability claims for damages, Repairs of
returned goods, Freight on repairs to returned goods, Cost of displeasure i.e.
opportunity cost on lost sales, Installation of FG at customer site, Ensure
quality supply of spare parts for AMC through sub-contractor, Discount Due to
Defects, etc

13. How does Total Quality Management (TQM) facilitate value addition in an organisation ?
(4 marks)
Answer
Total quality Management (TQM) is defined as a set of concepts and Tools for getting all employees
focused on continuous improvements in the eyes of the customer.

Since TQM focuses the attention of an organisation on quality, thus it helps to provide the customer
with much higher quality at a prudent cost. The organisations constantly strive for improvement so
that more and more value can be added through improved quality of product at lower cost.

14. Discuss the benefits accruing from the implementation of a Total Quality Management programme in
an organization. (marks 4)

Answer
The benefits accruing from the implementation of a Total Quality Management programme in an
organization are:

(i) There will be increased awareness of quality culture in the organization.

(ii) It will lead to commitment to continuous improvement.
(iii) It will focus on customer satisfaction.
(iv) A greater emphasis on team work will be achieved.

15. Explain four P’s of quality improvement principle. (Marks 4)

Solution
The Four P’s quality improvement principles are as below:
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1. People: It will quickly become apparent that some individuals are not ideally suited to the
participatory process. Lack of enthusiasm will be apparent from a generally negative approach
and a tendency to have prearranged meeting which coincide with the meetings of TOM teams.

2. Process: The rhetoric and inflexibility of a strict Deming approach will often have a de-
motivating effect on group activity.

3. Problem: Experience suggests that the least successful groups are those approaching
problems that are deemed to be too large provide meaningful solutions within a finite time
period.

4. Preparation: A training in the workings of Deming- like processes is an inadequate preparation

for the efficient implementation of a quality improvement process.

16. Classify the following items under appropriate categories of equality costs viz. Prevention Costs,
appraisal Cost, Internal Failure Costs and External Failure costs:

(i) Rework
(ii) Disposal of scrap
(iii) Warranty Repairs
(iv) Revenue loss
(v) Repair to manufacturing equipments
(vi) Discount on defective sale
(vii) Raw material inspection
(viii) Finished product inspection
(ix) Establishment of quality circles
(x) Packaging inspection (5 Marks)

Answers
i Rework Internal Failure
ii Disposal of Scrap Internal Failure
iii Warranty Repairs External Failure
iv Revenue Loss External Failure
v Repairs to Manufacturing Equipment Internal Failure
vi Discount on Defective Sales External Failure
vii Raw Material Inspection Prevention Cost
viii Finished Product Inspection Appraisal Cost
ix Establishment of Quality Circles Prevention Cost
x Packaging Inspection Appraisal Cost

17. What are the universal beliefs in respect of TQM?

Solution:
Following are the universal Total Quality Management beliefs:
(i) Owner / customer satisfaction is the measure of quality.
(ii) Everyone is an owner/customer.
(iii) Quality improvement must be continuous.
(iv) Analysis of the processes is the key to quality improvement.
(v) Measurement, a skilled use of analytical tools, and employee involvement are critical sources
of quality improvement ideas as innovations.
(vi) Sustained total management is not possible without active, visible, consistent, and enabling
leadership by managers at all levels.
(vii) It is essential to continuously improve the quality of products and services that we provide to
our owners/customers.
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18. Describe Deming’s 14 points.

Solution:
1. “Create constancy of purpose towards 2. “Adopt the new philosophy”. The implication is
improvement”. Replace short-term reaction that management should actually adopt his
with long-term planning. philosophy, rather than merely expect the
workforce to do so.
3. “Cease dependence on inspection”. If 4. “Move towards a single supplier for any one
variation is reduced, there is no need to item.” Multiple suppliers mean variation between
inspect manufactured items for defects, feedstock.
because there won’t be any.
5. “Improve constantly and forever”. Constantly 6. “Institute training on the job”. If people are
strive to reduce variation. inadequately trained, they will not all work the
same way, and this will introduce variation.
7. “Institute leadership”. Deming makes a 8. “Drive out feat”. Deming sees management by
distinction between leadership and mere fear as counter productive in the long term,
supervision. The latter is quota and target- because it prevents workers from acting in the
based. organisation’s best interests.
9. “Break down barriers between departments”. 10. “Eliminate slogans”. Another central TQM idea
Another idea central to TQM is the concept of is that it’s not people who make most mistakes -
the ‘internal customer’, that each department it’s the process they are working within.
serves not the management, but the other Harassing the workforce without improving the
departments that use its outputs. processes they use is counter- productive.
11. “Eliminate management by objectives”. 12. “Remove barriers to pride of workmanship”.
Deming saw production targets as Many of the other problems outlined reduce
encouraging the delivery of poor-quality worker satisfaction.
goods.
13. “Institute education and self improvement”. 14. “The transformation is everyone’s job”.
19. Write a note on the ‘Plan-Do-Study-Act’ cycle. Or Write a note on ‘Shewhart’ cycle. Or Write a note
on ‘Deming Wheel’. ( marks 4)

Solution:
The Plan-Do-Study-Act (PDSA) Cycle describes the activities a company needs to perform in order
to incorporate continuous improvement in its operation. This cycle, is also referred to as the
Shewhart cycle or the Deming wheel. The circular nature or this cycle shows that continuous
improvement is a never-ending process. Let’s look at the specific steps in the cycle.
(i) Plan: The first stop in the PDSA cycle is to plan. Managers must evaluate the current process
and make plans based on any problems they find. They need to document all current
procedures, collect data, and identify problems. This information should then be studied and
used to develop a plan for improvement as well as specific measures to evaluate
performance.
Continual
(ii) Do: The next stop in the cycle is implementing the plan (do). During the implementation
activities
process managers should document all changes made and collect data for evaluation.
(iii) Study / Check: The third step is to study the data collected in the previous phase. The data
are evaluated to see whether the plan is achieving the goals established in the plan phase.
(iv) Act: The last phase of the cycle is to act on the basis of the results of the first three phases.
The best way to accomplish this is to communicate the results to other members in the
company and then implement the new procedure if it has been successful.

PLAN
 Formulation of basic policy
 Planning of concrete action
plans
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ACTION DO
 Review of policy and plans  Practices through
based on audit results  Education/enlightenment
 Respond to risks activities
 Request corrective action

Note that this is a cycle; the next stop is to plan again. After we have acted, we need to continue
evaluating the process, planning and repeating the cycle again

20. Write a note on “Criticisms of Total Quality Management” (marks 4)

Solution:
Some authors, notably Carlzon (1987), Albrecht (1985) and Albrecht and Zemke (1988) have
criticized the direction that TQM implementations have tended to take in practice, in particular

 the focus on documentation of process and ill-measurable outcomes;

 the emphasis on quality assurance rather than improvement; and
 an internal focus which is at odds with the alleged customer orientation.

Carlzon has revived the customer focus with an emphasis on total employee involvement (TEI)
culminating in the empowerment of the ‘front-line’ of customer service troops. The main features of
his empowerment thrust has been:
 loyalty to the vision of the company through the pursuit of tough, visible goals;
 recognition of satisfied customers and motivated employees as the true assets of a company;
 delegation of decision-making to the point of responsibility by eliminating hierarchical tiers of
authority to allow direct and speedy response to customer need; and
 decentralization of management to make best use of the creative energy of the workforce.

Albrecht suggest that TQM may not be appropriate for service based industries, because the
standards-based approach ignores the culture of organizations. He recommends TQS (total quality
service), which is more customer oriented and creates an environment to promote enthusiasm and
commitment. Albrecht suggests that poor service is associated with sloppy procedures, errors,
inaccuracies and oversights and poor coordination. These factors represent improvement
opportunities which can be achieved through tighter controls.
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21. A Ltd. is going to introduce Total Quality Management (TQM) in its company. State whether and why
the following are valid or not for the successful implementation of TQM.
(i) Some departments serve both the external and internal customers. These departments have
been advised to focus on satisfying the needs of the external customers.
(ii) Hold a training program at the beginning of a prod. cycle to ensure the implementation of TQM.
(iii) Implement Management by Objectives for faster achievement of TQM.
(iv) Appoint the Head of each department as the person responsible to develop improvement
strategies and performance measures.
(v) Eliminate wastage of time by avoiding documentation and procedures. (5 Marks)

Answer
Point Valid/Invalid Reason
Invalid TQM advocates focus to be given on both external and internal
customers. Hence, focus satisfying the needs of the external customers
only will not be valid for the successful implementation of TQM.
Valid Training at the beginning would improve productivity by bringing
standardization in work habits and eliminating variations in production.
Invalid For implementation of TQM, Management by Objectives should be
eliminated as targets of production will encourage delivery of poor quality
goods and thus will defeat the collective nature of TQM.
(iv) Invalid Appointing the head of each department as the responsible person is not
valid for the successful implementation of TQM as Total Employee
Involvement (TIE) principle is an important part of TQM.
Invalid Documentation, procedures and awareness of current best practice are
essential in TQM implementation. If documentation and procedures are
in place then only improvement can be monitored & measured and
consequently deficiency can be corrected.
Assignment
1. In an assignment problem to assign jobs to men to minimise the time taken, suppose that one man
does not know how to do a particular job, how will you eliminate this allocation from the solution?
(marks 4)
Solution: In an assignment minimization problem, if one task cannot be assigned to one person, introduce
a large cost (i.e. M) for that allocation, where M has a high the value. Then perform the row minimum
and column minimum operations and automatically this allocation will get eliminated.

2. Prescribe the steps to be followed to solve an assignment problem. (3 Marks)

Answer: The assignment problem can be solved by applying the following steps.

Step1: Subtract the minimum element after row operation of each row from all the elements in that
row. Then perform the column minimum operation. The resulting matrix is the starting matrix for the
following procedure.

Step2: Draw the minimum number of horizontal and vertical lines that cover all the zeros. If this
number of lines = no of row or column, optimal assignment can be made by skipping steps 3 and 4
and proceeding with step 5. If, however, this number is less than n, go to the next step

Step3: We select the smallest element out of the uncovered numbers. Subtract this element from all
such (uncovered) elements and add it to the elements at the intersections of the horizontal and
vertical lines. Do not alter the covered elements.
Step4: Repeat steps 1, 2 and 3 until we get the minimum number of lines equal to n.
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Steps5 (A): Select a row or column with single 0 and surround this zero by a box  , indication of an
assignment there. Draw a vertical line through the column containing this zero. This eliminates any
confusion of making any further assignments in that column. Process all the rows in this way.

Step5 (B): Apply the same treatment to columns also. No unmarked () or uncovered (by a line)
zero is left, There may be more than one unmarked zero in one column or row. In this case, put
around one of the unmarked zero arbitrarily and pass 2 lines in the cells of the remaining zeros in its
row and column. Repeat the process until no unmarked zero is left in the matrix.

3. Answer the following independent situations in an assignment problem with a minimization objective:
(i) Just after row and column minimum operations, we find that a particular row has 2 zeroes.
Does this imply that the 2 corresponding numbers in the original matrix before any operation
were equal? Why?
(ii) Under the usual not usual notation, where a32 means the element at the intersection of the 3rd
row and 2nd column, we have, in a 4 × 4 assignment problem, a 24 and a32 figuring in the optimal
solution. What can you conclude about the remaining assignments? Why? (4 Marks)
Answer
(i) Two zeros does not necessarily imply two equal values in the original assignment matrix just
before row and column operations. Two zeroes in a same row can also be possible by two
different operations i.e. one zero from row operation and one zero from column operation.

(ii) The order of matrix in the assignment problem is 4 × 4. The total assignment (allocations) will be
four. In the assignment problem when any allocation is made in any cell then the corresponding
row and column become unavailable for further allocation. In the given assignment matrix two
allocations have been made in a24 (2nd row and 4th column) and a32 (3rd row and 2nd column). This
implies that 2nd and 3rd row and 4th and 2nd column are unavailable for further allocation.
Therefore, the other allocations are at either at a11 and a43 or at a13 and a41.
Simulation
It is a day-to-day estimation on numerical basis for conducting experiments that involve certain types of
mathematical and logical relationship to explain the behavior and structure of a complex real world system.
For example daily cash requirement in the branches of of a bank as it differs from one branch to another,
daily supply & demand of of a cold drinks company, waiting time in the cash counter of a shopping mall etc.

To develop a simulated model, its elements are analysed and expressed in terms of probability distribution
function. The elements so specified are collected in a natural order of occurrence and tested for various
alternatives that surface by the use of random numbers. The method using random number tables is known
as Monte Carlo Techniques. Random numbers are computed by different probalistic model such as –
Stochastic parameters, Exponential distribution, Erlang Distribution, Poisson distribution, Normal
distribution, etc. the most common method of generating random numbers is “Multiplicative Congruential
Method”.

1. Advantages : (3 marks)
--Where making observations in a real situation may be expensive & very difficult, the simulation
technique comes handy with the aid of a computers.
--The time, cost and risk involved in the experimentation of a real environment are avoided.
--Decision making becomes easier by observing the average of the results obtained by sufficient
runs of the set of data from theoretical population.

2. Disadvantages: (3 marks)
-- Simulation is not an optimization process. It only provides a set of system’s responses to
different operating conditions.
-- A good simulation model may be very expensive.
-- Not all situations can be evaluated by using simulation.
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-- Simulation does not generate the solution techniques.
-- It is a time consuming exercise.

3. Limitations (3 marks)
 Simulation generates a way of evaluating solutions but it does not generates the solutions
techniques.
 Sometimes simulation models are expensive & may also takes a long time to develop them.
 A simulation model does not produce answer by itself , nor all situations can be evaluated using
simulation.
 It is a trail and error approach that produces different solution in repeated runs.
 Simulation is time-consuming exercise.

4. Steps of Monte Carlo Method: (3 marks)

1. Clearly formulate the problem in order to determine the objectives and constraints.
2. Calculate respective probability on basis of occurrence of natural numbers or follow the order
of the activities ( in case of service sector) as given in the problem.
3. Calculate cumulative probability. (<)
4. Calculate random interval : if 2 digit random number given in the problem, Upper limit of the
interval = ∑ Probability x 100 - 1.
If 1 digit random number given , Upper limit of the interval = ∑Probability x 10 - 1.
If 3 digit random number given , Upper limit of the interval = ∑Probability x 1,000 - 1.
5. Select a random number & check the place of that in random interval
Correlate the random numbers with the factors/Items in the problem.
Summarize and examine the results in an appropriate table.
6. Evaluate the results of the simulation and select best course of action.

5. Few Management Applications Of Simulation: (marks 3)

1. Examine government fiscal actions with an econometric model of the Indian economy.
2. Analyzing where to locate factories (or plants) and warehouses in order to be able to distribute
goods at the lowest cost and prevent pollution.
3. Examine a series of marketing policies to find the best product mix, price, production, consumer
behavior prediction, promotion levels and advertising allocation.
4. Finding the level of plant and machinery maintenance scheduling concerning airlines, glass and
steel furnaces, shipyard, job shop, etc. to minimize service and breakdown costs.
5. Evaluating alternative investment opportunities, financial forecasting and insurance manpower
hiring decisions.
6. Testing a series of inventory order policies to find the least cost order poin
7. Military studies of logistics, support planning and weapon system effectiveness & etc.
8. Inventory control – Raw material spares, Demand simulated and reorder point determined.
9. Inventory –of finished goods –how to produce, by simulating external demand
10. Waiting time for servicing by simulating arrival and service times. Used by banks, doctors etc.
11. Checking defectives and determining percentage to formulate standards.

6. How Monte Carlo simulation is useful in inventory control? (marks 3)

Answer:
The distribution of demand during the lead-time can be obtained from past data. The cumulative
probability distribution of demand during the lead time is used as a basis to determine the annual
inventory costs and stock-out costs for different levels of the safety stock with the use of Monte Carlo
solution technique. The management can experiment the effect of various inventory policies by
using simulation and finally by selecting an optimum inventory policy. The purpose of simulation is
to help the management in selecting an inventory policy that will result in minimum inventory costs
viz. ordering, carrying and stock-out.
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7. State major reasons for using simulation technique to solve a problem and also describe basic steps
in a general simulation process. (Marks 5)

Answer
Reasons:
(i) It is impossible to develop a mathematical model.
(ii) It may be too costly.
(iii) Sufficient time may not be available to allow the system to operate for a very long time.
(iv) Actual operation and observation of a real system may be too disruptive.

Steps: check Q: 4

Network analysis: P.E.R.T,C.P.M & Resource Allocation

1. Define project. State some of its characteristics.

A project can be defined as a set of activities that are performed in a certain sequence determined
logically or technologically and it has to be completed within (I) a specified time, (ii) a specified cost
and (iii) meeting the performance standards. A project is a new work for which organisation has no
preliminary experience .

Examples of a project from fairly diverse fields could be cited . Some of them are given below :

1. Introducing a new product in the market.

2. Construction of a new bridge over a river or construction of a 25 -- storied building.

3. Executing a large and complex order on jobbing production.

4. Sending a space craft to the mars.

All these projects are characterized by the following set of common implications, although they
pertain to widely different fields.

(i) The large-scale characteristic : These projects are generally unusually large and complex.
Thousands of suppliers, workers and other categories of persons are involved and their efforts
have to be co-ordinate for completion of the project.
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(ii) The non-recurring characteristic : These projects are generally of a one time nature. Neither
in the past, nor in the future they are likely to be undertaken substantially in the same form.

(iii) Uncertain and critical dates : Duration of the various activities involved in such projects are
usually uncertain. Further in such type of projects, many critical dates exist by which operations
must be completed in order to complete the entire project on schedule.

(iv) Completion dead line : The fourth distinct feature of these projects is that there is dead line for
the completion of the entire project. In case of any delay in the completion of the project, some
penalty is levied for such delay beyond the dead line.

2. Explain the terms Resource Smoothing and Resource Leveling. (4 marks)

Resource smoothing :
It is a technique used for smoothening peak resource requirements during different periods of a
project net work. The total product duration is maintained at the minimum level. The constraint is on
the project duration time. It helps to estimate the total resource requirements for various projects. In
resource smoothing, time scaled diagram of various activities of a project and their floats along with
their resource requirements are used. The period of maximum demand for resources are identified
and non critical activities during these periods are staggered by rescheduling them according to their
floats for balancing the resource requirements.

Resource Leveling
It is a net work technique used for Reducing the requirement of a particular resource due to its
scarcity. It utilises the large floats available on non critical activities and cuts down the demand on
resources. The maximum demand of a resource should not exceed the available limit at any point of
time . Non critical activities are rescheduled by utilizing their floats.

3. ADVANTAGES OF CRITICAL PATH ANALYSIS (3 marks)

1. It allows for a comprehensive view of the entire project. Because of the sequential and
concurrent relationships, time scheduling becomes very effective.
2. Critical path analysis offers economical and effective system of control based on the principle
management by exception i.e. need for corrective action arises only exceptional situations and
in most of other cases, performance is in conformity with the plans.
3. It is a dynamic tool of management which calls for constant review, a reformulation of the
network, and finding the current path of relevance and optimum resources allocations.

4. Time Scaled Diagrams : ( 2 marks)

In the network diagrams which we have considered, it has been stressed that the length of the
individual arrows has no relation to the duration of the activity which each arrow represented. It is of
course possible to draw the arrows to a time scale, and this can be a very useful method of
presentation for small networks.

5. ASSUMPTIONS OF PERT & CPM (4 marks)

1. Normal distribution may not always be applicable.
2. The formulae for the expected duration and S.D. are simplifications.
3. The errors owning to the aforesaid simplification and assumption may be compounded or
may cancel each other to an extent.
4. In computing the S.D. of the critical path independence of activities is implied. Limitations of
resources may invalidate the independence which exists by the very definition of an activity.
5. It may not always be possible to sort out completely identifiable activities and to state where
they begin and where they end.
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6. Time estimates have an element of subjective-ness and, to that extent, the techniques could
be weak.

6. Distinction between PERT and CPM (4 marks)

PERT CPM
1. PERT is used for non-repetitive jobs like 1. CPM is used for repetitive job like building
planning of assembly of the space. a house

2. it is a probabilistic model. 2. it is a deterministic model.

3. It is event-oriented as the results of analysis 3. it is activity-oriented as the result or

are expressed in terms of events. calculations for each activity.

4. It is applied mainly for planning and 4. it is applied mainly for construction and
scheduling research programmes. business problems.

5. PERT incorporates statistical analysis and 5. CPM does not incorporate statistical
thereby determines the probabilities. analysis.

6. PERT serves as useful control device by 6. CPM is not a control device. It helps to
calling attention to delays in project optimize the cost.
completion.

7. Explain the following in the context of a network: (marks 3+3=6)

(i) Critical path
(ii) Dummy activity.

Solution
(i) Critical Path:
Critical Path is a chain of activities that begin with the starting event and ends with ending event of a
particular project. It is that path that runs through a network with the maximum length of time or it
indicates the maximum possible time required for completion of a project. Critical path indicates the
minimum time that will be required to complete a project. It is determined after identifying critical
events. Critical path goes through critical events.
(ii) Dummy Activities:
Dummy Activity is that activity which does not consume time or resources. It is used when two or
more activities have same initial and terminal events. As a result of using dummy activities, other
activities can be identified by unique end events. These are usually shown by arrows with dashed
lines.

Dummy

8. List the 5 steps involved in the methodology of critical path analysis. (4 marks)
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Solution

The working methodology consist of following five steps:

1. Analyze and break down the project in terms of specific activities and/or events.
2. Determine the interdependence and sequence of specific activities and prepare a network.
3. Assign estimates of time, cost or both to all the activities of the network
4. Identify the longest or critical path through the network
5. Monitor/evaluate & control the project by rescheduling and reassignment of resources.

9. Under what circumstance PERT is more relevant? How? (4 Marks)

Answer
PERT is more relevant for projects with uncertainty associated with the activity durations. To take
these uncertainty into account, three kinds of times estimates are generally obtained. These are:
 The Optimistic Times Estimate: This is the estimate of the shortest possible time in which an
activity can be completed under ideal conditions. For this estimate, no provision for delays or
setbacks are made. We shall denote this estimate by to.

 The Pessimistic Time Estimate: This is the maximum possible time which an activity could take
to accomplish the job. It everything went wrong and abnormal situations prevailed, this would
be the time estimate. It is denoted by tp.
 The Most Likely Time Estimate: This is a time estimate of an activity which lies between the
optimistic and the pessimistic time estimates. It assumes that things go in a normal way with
few setbacks. It is represents by tm.

10. State the types of errors in logical sequencing may arise while drawing a network diagram?
(4 marks)
Solution:
Generally three types of errors in logical sequencing may arise while drawing a network diagram,
particularly when it is a complicated one. These are known as looping, dangling and redundancy.
(i) Looping: Normally in a network, the arrow points are from left to right. This convention is to be
strictly adhered, as this would avoid illogical looping. Looping error is also known as Cycling
error.

(ii) Dangling: Activity which is not connected to any of the intermediate events or end event is
called dangling activity. The situation represented by the following diagram is also at fault, since
the activity represented by the dangling arrow 9- 11 is undertaken with no result.

To overcome the problem arising due to dangling arrows, following rules may be adopted.
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(a) All events, except the first and the last, must have at least one activity entering and one
activity leaving them, and
(b) All activities must start and finish with n event.

(iii) Redundancy: When dummy activities are inserted in a network diagram unnecessarily, this
type of error is called error of redundancy. It is shown in the following figure:

Redundancy Error

11. Writes short notes on: (3 marks each)

(i) Merge Event (ii) Burst Event

(iii) Interfering Float (iv) Independent Float
(v) Slack Time for an Event

Solution:

(i) Merge Event: If an event represents the joint completion of more than one activity i.e., a particular
point (termed as event) where two or more activities complete is called merge event (see following
figure).

Merge event

(ii) Burst Event: If an event represents joint initiation i.e., a particular point (termed as event) form
where more than one activities start, is called Burst event (see following figure).

Burst event

(iii) Interfering Float: It can be defined as that part of the total float which causes a reduction in the float
of the successor activities. In other words, it can be defined as the difference between the latest
finish time of the activity under consideration and the earliest start time of the following activity,

(iv) Independent Float: It is defined as that portion of the total float within which an activity can be
delayed without affecting float of the preceding activities. It is computed by subtracting the tail event
slack from the free float of an activity.The independent float is always either equal to or less than the
free float of an activity. If a negative value is obtained, the independent float is taken to be zero.
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(v) Slack Time for an Event: The slack time or slack of an event in a network is the difference between
the latest event time and the earliest event time.

12. State any 2 advantages of CPM.

Solution:
(i) It allows for a comprehensive view of the entire project. Identifying the critical activities keeps
the executive alert and in a state of preparedness, with alternative plans ready. Breaking down
the project into smaller components permits better and closer control;

(ii) Critical path analysis offers economical and effective system of control based on the principle
of management by exception i.e. need for corrective action arises only in exceptional situations
and in most of other cases, performance is in conformity with the plans;

(iii) It is a dynamic tool of management which calls for constant review, a reformulation of the
network, and finding the current path of relevance and optimum resources allocation.

13. List basic steps involved in drawing a CPM/PERT network.

Solution:

(i) Breaking up of the entire project into smaller activities.

(ii) For each task ascertain the activities and events to be performed.
(iii) For each activity determine the preceding and succeeding activities.
(iv) For each activity determine or estimate the time and other resources needed.
(v) Draw a network depicting the assembly of tasks into a project.

14. Write a short note on ‘Updating the Network’

Solution:
The progress of various activities in a project network is measured periodically. Normally, either most
of the activities are ahead or behind the schedule. It is therefore, necessary to update or redraw the
network periodically to know the exact position of completion of each activity of the project.

The task of updating the network may be carried out once in a month. Sometimes the updating of the
network may provide useful information to such an extent that the revision of succeeding activities
are re-estimated, or logical sequence may change. It is also possible that the total work
accomplished at a point of time may exceed what was planned.

15. Write a short note on ‘Activity Cost Slope’

Solution:
Activity Cost Slope: The cost slope indicates the additional cost incurred per unit of time saved in
reducing the duration of an activity. It can be understood more clearly by considering the figure.

Let OA represent the normal time duration for completing a job and OC the normal cost involved to
complete the job. Assume that the management wish to reduce the time of completing the job to OB
from normal time OA. Therefore under such a situation the cost of the project increases and it goes
up to say OD (Crash Cost). This only amounts to saving that by reducing the time period by BA the
cost has increased by the amount CD. The rate of increase in the cost of activity per unit with a
decrease in time is known as cost slope and is described as below.
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Crash E
Cost D
Cost

Normal C F
Cost

O B A
Crash Time Normal Time
Duration

OD  OC
Activity Cost Slope = CD =
AB OA  OB

= Crash Cost  Normal Cost

Normal Time  Crash Time
Transportation
1. What are the common methods of obtaining initial feasible solution in a transportation problem.
(3 marks)
Answer
Common method of finding initial solution in a transportation problem are :
-- Northwest corner rule
-- Least cost method or inspection method
-- Vogel’s approximation method.

2. State the methods in which initial feasible solution can be arrived at in a transportation problem.
Answer
The methods by which initial feasible solution can be arrived at in a transportation model are :
(i) North West Corner Method.
(ii) Least Cost Method
(iii) Vogel’s Approximation Method (VAM)

3. Explain the term degeneracy in a transportation problem. (Marks 4)

Solution
If a basic feasible solution of transportation problem with m origins and n destinations has fewer than
m + n – 1 positive xij (occupied cells) the problem is said to be a degenerate transportation problem.
Such a situation may be handled by introducing an infinitesimally small allocation e in the least cost
and independent cell.
While in the simple computation degeneracy does not cause any serious difficulty, it can cause
computational problem in transportation problem. If we apply modified distribution method, then the
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dual variable ui and vj are obtained from the Cij value to locate one or more Cij value which should
be equated to corresponding Cij + Vij.

4. How do you know whether an alternative solution exists for a transportation problem? (marks 2)

Solution
When cost p.u. of an un-occupied cell = (ui +vj) of that cell, then it is known as alternative solution. It
indicates that if the cell is brought into the solution, the total cost will not change but allocation
changes.

5. In an unbalanced minimization transportation problem, with positive unit transport costs from 3
factories to 4 destinations, it is necessary to introduce a dummy destination to make it a balanced
transportation problem. How will you find out if a given solution is optimal? (Marks 2)
Solution
Test for optimality: number of allocation = m+n-1 where there are m rows and n columns. The
allocations are independent i.e. if no loop can be formed by them.
Here, no of factories +no of destination +dummy-1 = m+n+1- 1 = 3+4+1 -1 = 7.
There should be exactly 7 allocation to satisfy (i) above.

6. Will the initial solution for a minimization transportation problem obtained by Vogel’s Approximation
Method and the Least Cost Method be the same? Why?
Answer
The initial solution need not be the same under both methods.

Vogel’s Approximation Method uses the differences between the minimum and the next minimum
costs for each row and column. This is the penalty or opportunity cost of not utilizing the next best
alterative. The highest penalty is given the 1st preference. This need not be the lowest cost.
For example if a row has minimum cost as 3, and the next minimum as 2, penalty is 1; whereas if
another row has minimum 4 and next minimum 6, penalty is 2, and this row is given preference. But
least cost given preference to the lowest cost cell, irrespective of the next cost.

Vogel’s Approximation Method will to result in a more optimal solution then least cost. They will be
the same only when the maximum penalty and the minimum cost coincide.

7. In a transportation problem for cost minimization, there are 4 rows indicating quantities demanded
and this totals up to 1,200 units. There are 4 columns giving quantities supplied. This totals up to
1,400 units. What is the condition for a solution to be degenerate? (3 Marks)

Answer
The condition for degeneracy is that the number of allocations in a solution is less than m+n-1.
The given problem is an unbalanced situation and hence a dummy row is to be added, since the
Column quantity is greater that that of the Row quantity. The total number of Rows and Columns
then = 9 i.e. (5+4). Therefore, m+n-1 = 8, i.e. if the number of allocations is less than 8, then
degeneracy would occur.

8. Define the following terms in relation to a transportation problem : Prohibited routes (Marks 4)

Answer
Sometimes in a given transportation problem, some routes may not be available. There could be
several reasons for this such as bad road conditions or strike etc. In such situations, there is a
restriction on the route available for transportation. To handle such type of a situation, a very large
cost (or a negative profit for the maximization problem) represented by  or ‘M’ is assigned to each
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of such routes which are not available. Due to assignment of very large cost, such routes would
automatically be eliminated in the final solution. The problem is the solved in its usual way.

9. Can there be (i) more than one dummy row or column or (ii) one dummy row and a dummy column
in a given problem of (a) assignment (b) transportation? Why? (In other words, state whether and
why each of situation A, B, C and D is possible or not):

Assignment Transportation
More than one dummy row or column A B
One dummy row and one dummy column C D
(4 Marks)
Answer
Situation Assignment Transportation
More than one A: Possible B: Not Possible
Dummy row or Reason: In assignment problem the Reason: the given problem should
column matrix should be square matrix i.e. no. be balanced i.e. total capacity (or
of rows = no. of column. In case of supply) = total requirement (or
unbalanced assignment problem where demand). If they are not equal, a
matrix is not square matrix, either dummy row/ column is introduced.
dummy rows or dummy columns would
be added to make it a square matrix.
One Dummy C: Not Possible D: Not Possible
row and one Reason: As explained above, either Reason: In case of unbalanced
Dummy dummy rows or dummy columns would transportation problem, only one
column be added to transform unbalanced dummy row/ column can be added.
matrix into square matrix, both row and
column cannot be added together.

10. In a 3 x 4 transportation problem for minimizing costs, will the R 2C1 cell (at the intersection of the 2 nd
row and 1st column) always figure in the initial solution by the North West Corner Rule? Why?
(4 Marks)

Answer
The Initial solution obtained by the North-West Corner Rule in transportation need not always
contain the R2C1 cell. In the North-West Corner Rule the first allocation is made at R 1C1 cell and then
it only moves towards R2C1 cell when the resources at the first row i.e. R1 is exhausted first than the
resources of first column i.e. C1. On the contrary if resources at first column i.e. C 1 is exhausted first
then the next allocation will be at R1C2.

For example the resource availability at first row (R1) is 1,500 units and the demand in first column
(C1) is 1,000 units. In this case resource availability of first row (R 1) will be exhausted to the extent of
the demand in first column (C1) first and then the remaining resources availability at first row (R 1) will
be used to meet the demand of the second column (C 2). In this example cell R2C1 will not come in
initial solution obtained by the North-West Corner Rule.
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Short Notes:
1. Automated manufacturing 
Automated manufacturing is a manufacturing method that relies on the use of computerized control
systems to run equipment in a facility where products are produced. Human operators are not
needed on the assembly line or manufacturing floor because the system is able to handle both the
mechanical work & the scheduling of manufacturing tasks. The development of fully
automated manufacturing systems dates to the later half of the 20th century, and
this manufacturing technique is used in facilities of varying scale all over the world.

Historically, manufacturing was done entirely by hand. This required large amounts of labor, driving
up the cost of the final product, and also exposed workers to considerable danger. During the
Industrial Revolution, mechanized manufacturing was introduced. In mechanized manufacturing,
workers operate equipment that does the labor, instead of laboring directly. This reduced costs,
improved consistency, and contributed to developments in workplace safety.
Automated manufacturing was the next step in the process of refining and modernizing
manufacturing methods.

In a fully automated facility, there are no humans on the floor. Automatic equipment does the work,
as ordered by control systems. These systems utilize complex software that can
schedule manufacturing tasks and run diagnostics on equipment that appears to be malfunctioning.
Cameras connected to sophisticated software can be used to monitor product quality, the speed of
the assembly line, and so forth. Humans are involved primarily in maintenance of the equipment and
programming of the control systems.
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The main advantages of automation are:

 Replacing human operators in tasks that involve hard physical or monotonous work.[2]

 Replacing humans in tasks done in dangerous environments (i.e. fire, space, volcanoes,
nuclear facilities, underwater, etc.)

 Performing tasks that are beyond human capabilities of size, weight, speed, endurance,
etc.

 Economy improvement. Automation may improve in economy of enterprises, society or

most of humanity. For example, when an enterprise invests in automation, technology recovers
its investment; or when a state or country increases its income due to automation
like Germany or Japan in the 20th Century.

The main disadvantages of automation are:

 Technical Limitation. Current technology is unable to automate all the desired tasks.

 Security Threats/ Vulnerability: An automated system may have limited level of intelligence,
hence it is most likely susceptible to commit error.

 Unpredictable development costs. The research and development cost of automating a process

may exceed the cost saved by the automation itself.

 High initial cost. The automation of a new product or plant requires a huge initial investment in

comparison with the unit cost of the product, although the cost of automation is spread in many
product batches.

2. Synchronous manufacturing
The title ‘synchronous manufacturing’ was coined in 1984, when leading exponents of OPT felt that
the focus of the latter, as evidenced by its nomenclature, had become too narrow. The change in
name allowed the newly emerging procedures and concepts of JIT and TQM to be integrated with
the basic principles of OPT ( optimize production technique). It is interesting to note, however, that
the guiding force behind both OPT and synchronous manufacturing is the identification and
management of ‘bottleneck resources’  Eli Goldratt prefers to use the term ‘theory of constraints’.

Synchronous manufacturing has been defined as follows.

Synchronous manufacturing: An all-encompassing manufacturing management philosophy that
includes a consistent set of principles, procedures and techniques where every action is evaluated in
terms of the common global goal of the organisation.

Note the use of the world ‘philosophy’ in the definition: this is the key to distinguishing it from its
narrower, technique-based predecessor, OPT. The word ‘optimised’ in the latter implied that an
‘optimum’ position was possible, which runs counter to a belief in continuous improvement; and the
words ‘production’ and ‘technology’ failed to capture the richness of the range of constraints and
challenges faced by the firm in achieving its objectives  market constraints, and logistical,
managerial and behavioural constraints need to be added to the physical constraints of production
capacity.

A set of seven ‘principles’ are associated with synchronous manufacturing:

1. Do not focus on balancing capacities, focus on synchronising the flow.
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2. The marginal value of time at a bottleneck resource is equal to the throughput rate of the
products processed by the bottleneck.
3. The marginal value of time at a non-bottleneck resource is negligible.
4. The level of utilisation of a non-bottleneck resource is controlled by other constraints within the
system.
5. Resources must be utilised, not simply activated.
6. A transfer batch may not, and many times should not, be equal to the process batch.
7. A process batch should be variable both along its route and over time.

3. Optimized production technology (OPT)

The OPT philosophy contends that the primary goal of manufacturing is to make money. Three
important criteria are identified to evaluate progress towards achieving this goal. These are
throughput, inventory and operating expenses. The goal is to maximize throughput while
simultaneously maintaining or decreasing inventory and operating expenses.

The OPT approach determines what prevents throughput from being higher by distinguishing
between bottlenecks and removing them or, if this is not possible, ensures that they are fully utilized
at all times. Non-bottleneck resources should be scheduled and operated based on constraints
within the system, and should not be used to produce more than the bottlenecks can absorb. The
OPT philosophy therefore advocates that non-bottleneck resources should not be utilized to 100% of
their capacity, since this would merely result in an increase in inventory. Thus idle time in non-
bottleneck areas is not considered detrimental to the efficiency of the organization. If it were utilized,
it would result in increased inventory without a corresponding increasing in throughput for the plant.

With OPT approach, it is vitally important to schedule all non-bottleneck resources within the
manufacturing system based on the constraints of the system (i.e. the bottlenecks). For example, if
only 70% of the output of a non-bottleneck resource can be absorbed by the following bottleneck
resources, then 30% of the utilization of the non-bottleneck is simple concerned with increasing
inventory. It can therefore be argued that by operating at the 70% level, the non-bottleneck resource
is achieving 100% efficiency.

4. Business process re-engineering (BPR)

It involves examining business processes and making substantial changes to how the
organisation currently operates. It involves the redesign of how work is done through
activities. A business process consists of a collection of activities that are linked together in
a co-ordinated manner to achieve a specific objective. For example, material handling
might be classed as
a. scheduling production, b. storing materials,
c. processing purchase orders, d. inspecting materials and
e. paying suppliers.

BPR is to improve the key business process in an organisation by focusing on

a. simplification, b. cost reduction,
c. improved quality and d. enhanced customer satisfaction.

The end result might be the elimination, or a permanent reduction, of the storing,
purchasing and inspection activities. These activities are non-value added activities since
they represent an opportunity for cost reduction without reducing the products’ service
potentials to customers.

A distinguishing feature of business process re-engineering is that it involves radical and

dramatic changes in processes by abandoning current practices and reinventing completely
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new methods of performing business processes. The focus is a major changes rather than
marginal improvements.

5. Tear-Down analysis

Tear down analysis (also known as reverse engineering) involves examining a competitor’s
product in order to identify opportunities for product improvement and/or cost reduction.
The competitor’s product is dismantled to identify its functionality and design and to provide
insights about the processes that are used and the cost to make the product. The aim is to
benchmark provisional product designs with the designs of competitors and to incorporate
any observed relative advantages of the competitor’s approach to product design.

6. Cost Leadership

By pursuing an overall cost leadership strategy, a firm can earn above-average returns in its industry
despite the presence of strong competitive forces. Cost leadership attained by consistent emphasis
on efficient production of a good or service, which makes the firm as a low-cost producer in the
industry.

For cost leadership the commonly required skills and resources are:
1. Sustained capital investment and access to capital, 2. Process engineering skills,
3. Intense supervision of labour, 4. Products designed for ease in Manufacture,
5. Low-cost distribution system.

The common organizational requirements are:-

1. Tight cost control,
2. Frequent detailed control reports,
3. Structure organisation and responsibilities,
4. Incentives based on meeting strict quantitative targets,

7. Kaizen costing

‘A Japanese term for continuous improvement in all aspects of a company’s performance, at every
level.’ Kaizen is the Japanese term for making improvements to a process through small
incremental amounts, rather than through large innovations.

Target costing is aimed at reducing the costs incurred because of the way the product is designed,
and occurs at the very start of the process. Kaizen costing is applied during the manufacturing stage
of the products life cycle. Kaizen costing therefore focuses on achieving cost reductions through the
increased efficiency of the production process. Improvement is the aim and responsibility of every
worker in every activity, at all times. Through continual efforts significant reductions in cost can be
achieved over time. In order to encourage continual cost reductions an annual (or monthly) Kaizen
cost goal is established. Actual results are then compared with the Kaizen goal and then the current
actual cost becomes the base line for setting the new Kaizen goal the following year. It should be
noted however that as the products are already at the production stage the cost savings under
Kaizen costing are smaller than target costing. Because cost reductions under target costing are
achieved at the design stage where 8090% of the product costs are locked in, more significant
savings can be made.

8. Kaizen Costing & Target Costing

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Kaizen Costing is widely used by Japanese organisation as a mechanism for reducing and
managing costs. Kaizen is the Japanese terms for making improvements to a process
through small incremental amounts, rather than through large innovations.

The major difference between target and Kaizen costing is

a. Target costing is applied during the design stage whereas Kaizen costing
is applied during the manufacturing stage of the product life cycle.

b. With target costing the focus is one the product, and cost reductions are
achieved primarily through product design. In contrast, Kaizen costing focuses on the
production process and cost reduction are derived primarily through the increased
efficiency of the production process.

Therefore the potential cost reductions are smaller with Kaizen costing because the
products are already in the manufacturing stage of their life cycles and a significant
proportion of the costs will have become locked-in.

The aim of Kaizen costing is to reduce the cost of components and products by a pre-
specified amount. Monden & Hamada (1991) describe the application of Kaizen costing in a
Japanese automobile plant. Each plant is assigned a target cost reduction ratio and this is
applied to the previous year’s actual costs to determine the target cost reduction.

Kaizen costing relies heavily on employee empowerment. They are assumed to have
superior knowledge about how to improve processes because they are close to the
manufacturing processes and customers and are likely to have greater insights into how
costs can be reduced.

9. PB is a car production company. PB uses a system of standard costing to set its budgets. Budgets
are set annually by the Finance department and approved by the Board of Directors of PB. The
Finance department prepares variance reports each month for review at the Board of Directors
meeting, where actual performance is monitored by comparison to budgeted figures.
A new Finance Director has recently joined PB from a competitor organisation where there was a
Total Quality Management culture. The new Finance Director of PB is keen to discuss the
implementation of Kaizen costing at the next meeting of the Board of Directors. The new Finance
Director would like to review the current planning and control system at PB with a view to making
changes so that it could support Kaizen costing concepts.
(a) Explain TWO basic principles of Total Quality Management.
(b) Explain THREE changes required to PB’s planning and control system to support the adoption
of Kaizen costing concepts.
Answer
Total Quality Management has two basic principles: ‘get it right first time’ and ‘continuous
improvement’. Get it right first time essentially equates to aiming for a zero-defect target. This
principle is based on the premise that prevention costs are less than the cost of correction.
The principle of continuous improvement is based on the idea that, although the ideal state may
never be achieved, it is the aim. A target of zero defects may not be achievable. However, the
principle of never being satisfied until this is achieved will engender the correct behaviour of
continually seeking to improve.
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Kaizen costing is a system of cost reduction rather than cost control and is based upon attaining
incremental cost reductions by making continuous small changes in the product or the method of
operations.
As Kaizen costing is a system of cost reduction, PB would require different target information than at
present. Rather than setting a budget based on standard costs, the target would be the Kaizen cost.
Cost analysis in Kaizen costing requires the comparison of target Kaizen costs to actual cost
reductions. The performance reporting in PB would need to change from the current system of
comparing actual costs to budget costs to accommodate this.
Kaizen costing sets and applies cost reduction targets monthly. The current system of setting targets
(currently the annual budget at PB) once per year needs to change to accommodate more frequent
target setting.
10. Kanban Materials Acquisition System
Kanban is a Japanese word. It is a tool for implementing JIT production. In its most common form a
Kanban is simply a card that contains production information. This card identifies
a. the part number, b. delivery and work cell locations,
c. part descriptions, d. quantity,
e. company name and f. The card number within a series.
Often Kanban cards are bar-coded to facilitate ease of use. The implementation of Kanban
drastically changed the buyers’ activities. Under the new system the buyers
 Placed blanked orders with suppliers. Instead of suppliers receiving five to six large orders per
year, smaller Kanban quantities were requested often, on a daily basis.
 Made quality the primary factor. It is of no use to receive five or 500 parts if they are not
usable.
 Provided the support to supply economical amounts of inventory. Buyers no longer controlled or
were responsible for inventory levels and their delivery dates. Once the Kanban was formed,
the buyer acted as a facilitator, providing the necessary administration to support parts
movement.
Once the Kanban was in place, buyers found their relationships with the vendors had changed from
adversarial to a partnership. The vendors were thrilled with Kanban. The radical schedule and
production fluctuation they had been experiencing were gone. They now had visibility of what their
customer actually needed. They were able to respond immediately to demand.
11. Analysis of COMMON COSTS
Every organization has to incur a number of common costs i.e. the cost which are not direct to any
cost center, activity or service. Some of this common cost in relation to production, we have already
treated in intermediate/PE II level. Here some advance technique regarding apportionment of
common cost are discussed:
1. Direct method; 2. Step down method;
3. Reciprocal method; 4. Stand-alone cost allocation method;
5. Incremental cost allocation method
1. Direct method:

In this case the cost of the service or support department are distributed among the production
departments only on the basis of services render to the production department.

2. Step-down Method:
The cost of service department is to be distributed among the production and other service
departments. This is followed when among the service departments, one department has received
less service from the other service department as compare to the service provided to others by this
department.

3. Reciprocal Method:
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When the service departments are providing services to each other apart from servicing the
production department then this method is to be applied. For this purpose there are two techniques

1.Repeated distribution method; 2. Simultaneous equation method,

All this above 3 methods are discussed in detail in your previous level examination.

4. Stand alone cost allocation method:

When a common cost of operating a facility is reduced with the increase of its use, then the common
cost should be distributed in the ratio of the original cost. This is known as Stand alone method.
Example: The products A and B uses a common process in their production line. The individual
direct cost - for product A 200; and product B 150. The cost of the common process department –
Uses for product A only: 2,000
Use for product B only: 1,800. However if both the products are produced then the total cost is
3,000 instead of 2,000+1,800 = 3,800.
So we can distribute this common cost 3,000 in the ratio of 2,000: 1,800 i.e. 10: 9
Share of common cost for product A = 3,000× 10÷19 = 1,579
Share of common cost for product B = 3,000× 9÷ 19 = 1,421

5. Incremental Cost allocation method:

In this method the individual cost users is ranked 1 which one mostly liable for incurrence of the total
cost. Actually that product should be rank 1 which one is the primary user of the common cost. Any
increment to that common cost by the other user should be allotted to the secondary user. From the
above example product A is the primary user of the facility and product B is the secondary user. So
product A should be ranked 1 and product B should be ranked 2.

Share of common cost to Product A = 2,000

Share of common cost to product B = 3,000 – 2,000 = 1,000

12. Divestment Strategy:

Divestment involves a strategy of selling off or shedding business operations to divert the resources,
so released, for other purposes. Selling off a business segment or product division is one of the
frequent forms of divestment strategy. It may also include selling off or giving up the control over
subsidiary where by the wholly owned subsidiaries may be floated as independently quoted
companies.
Reason for Divestment Strategy
1. In case of a firm having an opportunity to get more profitable product or segment but have
resource constraint, it may selling off it’s unprofitable or less profitable division and utilized the
recourse so released. Cost Benefit analysis & Capita Budgeting Method are the useful tool for
analyzing this type of situation.
2. In case of purchase of new business, it may be found that some of the part of the acquired
business is not upto the mark. In such type of situation disposal of the unwanted part of the
business is more desirable than hold it. 3. In case where any business segment or product or
subsidiary is pull down the profit of the whole organization, it is better to cut down of that
operation of the product or business segment.

13. Pareto analysis:

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Pareto analysis is based on the 80:20 rule that was a phenomenon observed by Vilfredo Pareto.
According to him 80% of wealth of Milan in Italy was owned by 20% of its citizens. The phenomenon
can be observed in many different business situations & the management can follow it in various
circumstances to direct management attention to the key control mechanism or planning aspects.

Usefulness of Pareto analysis:

(a) Prioritize problems, goals and objectives
(b) Identify root causes
(c) Select and define key quality improvement programs
(d) Select key customer relations and service programs
(e) Select key employee relations improvement programs
(f) Select and define key performance improvement programs
(g) Maximize research and product development time
(h) Verify operating procedures and manufacturing processes
(i) Product or services sales and distribution
(j) Allocate physical, financial and human resources.

Applicability of Pareto analysis to business situations:

(i) Pricing of a product: In practice, it has been observed that 20% of products of a firm may
account for 80% of total sales revenue. Under such circumstances the firm can adopt more
sophisticated pricing method for small portion of products that jointly accounts for
approximately 80% of total sales revenue. For the remaining 80% of the products the firm
may use cost bases pricing method. Pareto analysis thus helps the management of the firm
to delegate the pricing decision for about 80% of its products to lower levels of management.

(ii) Customer profitability: Customers can also be analyzed instead of products, for their relative
profitability It has been often found that 20% of customers may generate 80% of sales
revenue profit. Such an analysis is useful for the evaluation of portfolio of customer profile.
(iii) Stock control: Approximately 20% of the total investment in quantity of stock may account for
about 80% of its investment. Since the number of items is small therefore the management
of a firm may be able to control most of the monetary investment in them.
(iv) Applicability in activity based costing: In ABC it is often said that 20% of an organisation cost
drivers are responsible for 80% of the total overhead cost. By analyzing, monitoring and
controlling those cost drivers that cause most cost a better control and understanding of
overheads may be obtained.
(v) Quality control: Pareto analysis seeks to discover from an analysis of defect report or
customer complaints which “vital few” causes are responsible for most of the reported
problems. Often 80% of underlying problems can usual be traced to 20% of the various
underlying causes.

14. Product bundling

Bundling is putting a package of products together to make, for example, a complete kit for
customers, which can then be sold at a temptingly low price. It is a way of creating value for
customers and increasing company profits.
It is a strategy that is often adopted in times of recession when organisations are particularly keen to
maintain sales volume. One industry where this tactic started in the recession of the early 1990s is
the computer industry. A manufacturer might decide to substantially reduce the profit margin on
some hardware, such as printers. If, for example, only half its PC purchasers would also buy the
company’s model of printer, a bundled package which includes the PC and the printer for a lower
combined price may well prove very successful. On the other hand, some customers will be put off
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by product bundling as they do not want the complete package; they will resent the increased price,
however small it is.
Bundling can be extremely successful, especially when tried on mature products for the first time.
For instance, Amstrad had considerable success when it entered the hi-fi market and demystified the
technology by being the first company to sell a complete package of amplifier, deck and speakers.
This was more than just a pricing strategy: it was a complete marketing strategy. In recent years the
telecommunications industry has successfully used this technique; first with TV channel packages,
and then more recently extended to TV, broadband and phone bundles.

15. Discuss the benefits of Customer Profitability Analysis. (4 Marks)

Answer
It helps the supplier to identify which customers are eroding overall profitability and which customers
are contributing to it.
(i) It can helps to provide a basis for constructive dialogue between buyer and seller to improve
margins.
(ii) It enhances decision making related to customers.
(iii) It helps in effective cost reporting, communication and information.
(iv) It helps to find out the value and profitability of each customer segment.

16. What is ‘Defective work’? how it is accounted for in cost accounts ? (5 marks)
Answer
‘Defective Work’ is the work output which does not meet out the prescribed laid down standard
specifications. Such a situation may arise due to various causes, such as use of sub – standard
materials, bad workmanship, carelessness in planning, laxity in inspection, etc. Defectives can be
reworked or reconditioned by the application of additional material, labour and/ or processing and
may be brought to the point of either standard work/products or sub –standard products. Reworked
units of defectives may be sold though regular channels as first or seconds as the case may be.

1. When defectives are normal and it is not beneficial to try to identify them job wise, the following
methods are generally used:
(a) Charged to good products: The cost of rectification of normal defectives is charged to
good units. This method is used when defectives rectified are normal.
(b) Charged to general overheads: Where the department responsible for defective cannot
be correctly identified, because defectives caused in one department are reflected only
on further processing, the rework costs are charged to general overheads.
(c) Charged to departmental overheads: If the department responsible for defectives can be
correctly identified, the rectification costs should be charged to that department.

2. Where normal defectives are easily identifiable with specific jobs, the rework costs are debited
to the jobs.
3. When defectives are abnormal and are due to causes within the control of the organisation,
the rework cost should be charged to the costing profit and loss account.

17. What is scrap? How it is accounted for in cost accounts? (6 marks)

Answer
Scrap: The incidental residue arising from the manufacturing operations, small in quantity and low in
value, recoverable without further processing.
Scrap may be treated in cost accounts in the following ways:

(i) Where the value of scrap is negligible, it may be excluded from costs. In other words, the cost
of scrap is to be borne by good units and income from scrap is treated as other income.
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(ii) If the scrap value is considerable, the net sale proceeds of scrap (gross sales proceeds of
scrap – the cost of selling scrap) is deducted from the material cost or factory overhead. Under
this method the material cost or factory overhead recovery rate is reduced on account of sale
proceeds of scrap.

(iii) Where the various jobs or processes give rise in varying amount of scrap, the scrap from each
job or process is recorded separately and the sale proceeds from the same credited to the
particular job or process. This method is useful where scrap is of considerable value and does
not arise uniformly. However, this would necessitate the scrap being identified with various jobs
or processes. For this purpose detailed records for scrap will be required.

18. State the principles to be followed in control and accounting of wastage. (7 marks)

Answer
The term wastage represents that portion of material which is lost in storage, handling and in
manufacturing process. It does not have any recoverable value. It may be invisible (unsaleable
remnants, residues etc.) or invisible (smoke, gases etc.) form.

Control of wastage: For control of wastage, allowance for normal waste should be made on the
basis of technical factors, special features of the material, nature of process and product and past
experience, if any. Actual yield and wastage should be compared with anticipated figures of yield
and wastage. Appropriate action should be taken to rectify the situation in the case of variation.
Responsibility should be fixed on storage, purchasing, maintenance, production and inspection staff
to maintain standards. A systematic procedure of feedback of achievement against standards laid
down be established.

Accounting of wastage: Waste may be classified as normal and abnormal and their accounting
treatment is as under:

(i) Normal wastage: It being a normal feature and inherent in the manufacturing operations.
Therefore it should be regarded as part of the production cost. It is absorbed in the production
cost of good units.
(ii) Abnormal wastage: This wastage is in excess of the standard percentage of wastage set up to
establish normal waste. Since it indicates excessive loss caused by unexpected or abnormal
conditions so its cost is transferred to the costing profit and Loss account.

19. A manufacturing company makes 4 products that are sold through 8 regional offices countrywide.
The products pass through 3 production processes in a factory. A separate market research division
monitors outside competition. This division is outside the sales management hierarchy.
As a management accountant, suggest some routine reports for performance measurement to be
made to:
(a) The sales Management
(b) The works Manger (9 Marks)
Solution
(a) To sales Management
(i) Actual is budgeted sales showing quantity, price and value
- Product wise
- Region wise
- Salesmen wise
- Customer wise
(Any 2 of the above)
(ii) Productwise Standard profit and loss
- For fixing selling pries
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- To concentrate on sales of more profitable products
(iii) Analysis of selling expense in relation to budgeted expenses and sales value
- Product wise, region wise
(iv) Bad debts and Accounts which are slow and difficult in collection
(v) Status report on new or doubtful customers
(b) To works Manager
(i) Product wise/ process wise operating statement
(ii) General works operating statements under suitable classification of expenses (items not
directly controllable by depts., but relating to works expenses)
(iii) Plant utilization report
(iv) Department wise scrap report
(v) Material usage report
(vi) Machinery failure report
(vii) Summary of plant wise labour efficiency
(viii) Plant accident report

20. How has the composition of manufacturing costs changed during recent Years? How has this
change affected the design of cost accounting systems?
Solution:
Traditionally, manufacturing companies classified the manufacturing costs to be allocated to the
products into (a) direct materials. (b) direct labour and (c) indirect manufacturing costs. In the
present day context, characterised by intensive global competition, large scale automation of
manufacturing process, computerization and product diversification to cater to the changing
consumer tastes and preferences has forced companies to refine their costing systems to provide
better measurement of the overhead costs used by different cost objects. Accordingly,
manufacturing costs are classified into three broad categories as under:
(i) Direct cost: As many total costs relating to cost objects as feasible are classified into direct
cost. The objective is to trace as many costs as possible in to direct and to reduce the amount
of costs classified into indirect because the greater the proportion of direct costs the greater the
accuracy of the cost system.
(ii) Indirect cost pools: Increase the number of indirect cost pools so that each of these pools in
more homogeneous. In a homogeneous cost pool, all the costs will have the same cause-and-
effect relationship with the cost allocation base.
(iii) Use cost-and-effect criterion for identifying the cost allocation base for each indirect cost pool.
The change in the classification of manufacturing costs as above has lead to the development of
Activity Based Costing (ABC). Activity Based Costing refines a costing system by focusing on
individual activities as the fundamental cost objects. An activity is an event, task or unit of work with
a specified purpose as for example, designing, set up, etc. ABC system calculates the costs of
individual activities and assigns costs to cost objects such as products or services on the basis of the
activities consumed to produce the product or provide the service.
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Uniform costing & Inter firm comparison

1. What is uniform costing? Why is it recommended?

Solution
Uniform Costing: It is not a distinct method of costing when several undertakings start using the
same costing principles or practices, they are said to be following uniform costing. Different concerns
in an industry should adopt a common method of costing and apply uniformly the same principles
and techniques for better cost comparison and common good and helps in mutual cost control and
cost reduction. Hence, it is recommended that a uniform method of costing should be adopted by the
member units of an industry.

2. Write points on which Uniformity is essential before introducing Uniform Costing ( marks 4)

The points in respect of which uniformity is required to be established before the introduction of
uniform costing in an industry are as below :

a. Uniformity in the size of various units where uniform costing is to be introduced.

b. The size of units should be more or less the same which are to be brought under uniform
costing. Units differing in size should be classified in a number of categories according to
their size. Since the cost structure in an organisation is influenced by its size, the
classification of units based on their size would make the cost statements of these units more
comparable.

c. Uniformity in the production method :

i. All units in an industry should use uniform methods of production.
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ii. Uniformity in the accounting method, principles and procedures.

In fact, the uniformity should be achieved in respect of following :

i. Identifying stages of production where costs are to be measured.

ii. Same methods of valuing inventory should be used.
iii. Cost unit.
iv. Classification of costs and its components.
v. Identifying methods of pricing material issues.
vi. Methods of remunerating and providing incentives to labour.
vii. Basis of allocation and apportionment of overheads.
viii. Basis of distribution and redistribution of overheads.
ix. Methods of depreciation.
x. Treatment of notional expenses.
xi. Treatment of material losses.
xii. Allocation / apportionment of joint costs.
xiii. Preparation of cost statements, reports and their submission schedule.

3. Requisites for installation of a Uniform Costing System : (marks3)

i. The firms in the industry should be willing to share/furnish relevant data/information.

ii. A spirit of cooperation and mutual trust should prevail among the participating firms.

iii. Mutual exchange of ideas, methods used, special achievements made research and known-
how etc., should be frequent.

iv. Bigger firms should take the lead towards sharing their experience and known-how with the
smaller firms to enable the latter to improve their performance.

v. Uniformity must be established with regard to several points before the introduction of
uniform costing in an industry. In fact, uniformity should be with regard to following points.
a. Size of the various units covered by uniform costing.
b. Production methods.
c. Accounting methods, principles and procedures used.

4. Uniform Cost Manual : (marks4)

It is a written document, which may be in the form of a booklet or bulletin, containing the principles,
methods and procedures for the ascertainment and control of cost in uniform costing. It is necessary
for the successful operation of uniform costing system. Such a manual provide guidelines to the
participating firms to organise their cost accounting system on a uniform basis.

The following are the salient features of a uniform cost manual.

a. It includes statement of objectives and purpose of the system, scope of the system,
advantages and extent of co-operation necessary.

b. It contains the general principles of accounting, nature of coding, terminology to be followed,

classification and description of accounts. This section also includes details of stock control,
labour and overhead cost collection and control.
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c. Essential cost data and various ratios to be computed for comparison of performance and
efficiency in the operation of the participation units.

d. Mode, format and time for presenting cost data and reports to the management.

e. It provides necessary guideline about the treatment of depreciation, interest on capital

wastage, scrap, by-product, etc.

5. Advantages of Uniform Costing. (marks 4)

I The management of an individual firm / unit will be saved of the botheration of developing
and introducing a costing system of their own.
ii. A uniform costing system for the firms in the same industry is provided for the adoption of
such undertakings. Since, the system is devised by mutual consultation and after
considering the difficulties and circumstances prevailing in the various undertakings,
therefore it is readily adopted and successfully implemented.
iii. It facilitates comparison of cost figures of various firms. Such a comparison enables the
firms to identify their weak and strong points and control costs effectively and efficiently.

iv. The available of cost data of other firms in the industry enables each firm to know its standing
in the industry.
6. Benefits: (marks 4)
a. The benefits of research and development of bigger firms are made available to smaller firms
at no cost.
b. This system of costing requires the introduction of a uniform wage system in all the firms in
the industry. The introduction of a uniform wage system reduces labour turnover.
c. It helps trade associations in negotiating with the government in trade matters, particularly,
when an industry seeks any assistance or concession from the government in matters of
subsidies, exports, taxation, duties and price determination, etc.
d. Uniform costing is of great help in price fixation. Unhealthy competition is avoided between
the firms in the same industry in framing policies and submitting tenders.
e. It helps the government also in regulating the prices of essential and important items such as
bread, flour, sugar, cement and steel etc.

7. Limitations of uniform costing : (marks 3)

(i) Sometimes it is not possible to adopt uniform standards, methods and procedures of costing
in different firms due to differing circumstances in which they operate. Hence, the adoption of
uniform costing becomes difficult in such firms.
(ii) Disclosure of cost information and other data is an essential requirement of a uniform costing
system. Many firms do not wish to share such information with their competitors in the same
industry.
(iii) Small firms in an industry believe that uniform costing system is only meant for big and
medium size firms, because they cannot afford it.
(iv) In induces monopolistic trend in the business, due to which prices may be increased
artificially and supplies withheld.

8. Inter-firm comparison : (marks 6)

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It is a technique of evaluating the performance, efficiency, costs and profits of firms in an industry. It
consists of voluntary exchange of information / data concerning cost, price, profits, productivity and
overall efficiency among firms engaged in similar type of operation for the purpose of bringing
improvement in efficiency and indicating weaknesses. Such a comparison will be possible in the
case of those concerns where uniform costing is an operation.
An inter–firm comparison indicates the efficiency of all important points and aspect in firm’s
management. It enables the management to challenge the standards which it has set for itself and to
improve upon them in the light of current information gathered from more efficient units.

Requisites for installing a system of inter – firm comparison

a. Creation of a centre for inter-firm comparison : For collection and analysis of data received
from different units in an industry, for the purpose of carrying out comparison and for
dissemination of the results of study, a central body / a centre is necessary. The main
functions of such a centre should include the following :

i. Collection of identified data and information from different units in an industry.

ii. Dissemination of results to its members.
iii. Undertaking r & d for common and individual benefits of its members.
iv. Organizing training programme and publishing magazines.

b. Membership of Centre : For better results it is necessary that firms of different sizes in an
industry should become members of the centre, entrusted with the tusk of carrying out inter–
firm comparison.

c. Identification of data and information requirement : The type and extent of data and
information required to be collected for inter – firm comparison, should be identified first .
In fact , the requirement of such information depends much on the needs of management
and the purpose of comparison. Generally, the following information are required :-
Cost and cost structure Raw material consumption
Stock of raw materials Wastages
Labour efficiency and utilisation Machine utilisation
Capital employed and return on capital Liquidity position
Reserve and appropriation of profits Creditors and debtors
Methods and techniques of production

d. Methods of collection and presentation of data / information : The centre collects identified
data and information for its members, at fixed intervals by using prescribed formats.
Sometime a questionnaire approach is also followed to gather necessary information. Data
and information received from members is utilised for preparing reports. These reports
present the data and information in the manner suitable to its users

9. What are the advantages of inter-firm Comparison? (marks 4)

Solution:
The main advantages of inter-firm Comparison are:

(i) Such a comparison gives an overall view of the industry as a whole to its members. The
present position of the industry, progress made during the past and the future of the industry.
(ii) It helps a concern in knowing its strengths or weaknesses in relation to others so that
remedial measures may be taken.
(iii) It ensures an unbiased specialized reporting on particular problem of the concern.
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(iv) It develops cost consciousness among members of the industry.
(v) It helps Government in effecting price regulation.
(vi) It helps to improve the quality of products manufactured and to reduce the cost of production.
It is thus advantageous to the industry as well as to the society.

10. What are the limitations of Inter-firm Comparison? (marks 4)

Solution:
The following are the limitations in the implementation of a scheme of Inter-firm Comparison:

(i) There is a fear of losing secrecy of the production method or some peculiar process or
method among the top management..
(ii) Middle management is usually not convinced with the utility of such a comparison.
(iii) In the absence of a suitable cost accounting system, the figures supplied may not be reliable
for the purpose of comparison.

(iv) Suitable basis for comparison may not be available.

Short questions:
1. For which of the following is a profit centre manager responsible?
A Costs only B Revenues only C Costs and revenues. Answer C

2. Which of the following best describes a flexible budget?

A A budget which shows variable production costs only.
B A monthly budget which is changed to reflect the number of days in the month.
C A budget which shows sales revenue and costs at different levels of activity.
D A budget that is updated halfway through the year to incorporate the actual results for the first
half of the year. Answer C

3. Which one of the following should be classified as indirect labour?

A Assembly workers on a car production line
B Bricklayers in a house building company
C Machinists in a factory producing clothes
D Forklift truck drivers in the stores of an engineering company. Answer D

4. The following statements relate to aspects of budget administration:

Statement (1): An important task of a budget committee is to ensure that budgets are properly
coordinated.
Statement (2): A budget manual is the document produced at the end of the budget setting process.
Which of the following is true?
A Only statement (1) is correct.
B Only statement (2) is correct.
C Both statements are correct. Answer A

5. A manufacturing organisation incurs costs relating to the following:

(1) Commission payable to salespersons.
(2) Inspecting all products.
(3) Packing the products at the end of the manufacturing process prior to moving them to
the warehouse. Which of these costs are classified as production costs?
A (1) and (2) only B (1) and (3) only
C (2) and (3) only D (1), (2) and (3) Answer C
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6. Which one of the following is most likely to operate a system of service costing?
(A) A printing company (B) A hospital (C) A firm of solicitors.
Answer B

7. In an organisation manufacturing a number of different products in one large factory, the rent of that
factory is an example of a direct expense when costing a product. Is this statement true or false? A
True B False Answer B

8. The following statements refer to organisations using job costing:

(i) Work is done to customer specification.
(ii) Work is usually completed within a relatively short period of time.
(iii) Products manufactured tend to be all identical.

Which two of these statements are CORRECT?

A (i) and (ii) B (i) and (iii) C (ii) and (iii) Answer A

9. When a manufacturing company operates a standard marginal costing system there are no fixed
production overhead variances. Is this statement true or false?
A True. B False Answer B
10. A company operates a standard costing system. The variance analysis for last month shows a
favourable materials price variance and an adverse labour efficiency variance. The following four
statements, which make comparisons with the standards, have been made:
(1) Inferior quality materials were purchased and used.
(2) Superior quality materials were purchased and used.
(3) Lower graded workers were used on production.
(4) Higher graded workers were used on production.
Which statements are consistent with the variance analysis?
A (1) and (3). B (1) and (4). C (2) and (3) D (2) and (4) Answer A

11. The following statements relate to relevant cost concepts in decision-making:

(i) Materials can never have an opportunity cost whereas labour can.
(ii) The annual depreciation charge is not a relevant cost.
(iii) Fixed costs would have a relevant cost element if a decision causes a change in their total
expenditure
Which statements are correct? A (i) and (ii) only B (i) and (iii) only C (ii) and (iii) only
D (i), (ii) and (iii) Answer C

12. A semi-variable cost is one that, in the short term, remains the same over a given range of activity
but beyond that increases and then remains constant at the higher level of activity.Is this statement
true or false? Answer False

13. The following statement refers to a quality of good information: The cost of producing information
should be greater than the value of the benefits of that information to management. Is this statement
true or false? Answer False

14. A manufacturing company benchmarks the performance of its accounts receivable department with
that of a leading credit card company. What type of benchmarking is the company using?
A Internal benchmarking B Competitive benchmarking
C Functional benchmarking D Strategic benchmarking Answer C

15. Which of the following BEST describes target costing?

A Setting a cost by subtracting a desired profit margin from a competitive market price
B Setting a price by adding a desired profit margin to a production cost
C Setting a cost for the use in the calculation of variances
D Setting a selling price for the company to aim for in the long run. Answer A
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16. Which of the following BEST describes a principle budget factor?

A A factor that affects all budget centres
B A factor that is controllable by a budget centre manager
C A factor that the management accountant builds into all budgets
D A factor which limits the activities of an organization. Answer D

17. Short Questions &Answers

(i) Name the pricing policy which aims at high selling price in the beginning of a product’s life
cycle?
(ii) Which accounting plan of standard costing helps to convert standards into Actual by using
the ratios?
(iii) What does excess of discounted cash-in- flow over discounted cash out-flow represent?
(iv) Enumerate the factors involved in decisions relating to expansion of capacity
(v) Given an appropriate cost unit for each of the following service sectors:
(i) Hotel (ii) School
(iii) Hospital (iv) Accounting firm
(v) Transport (vi) Staff Canteen
(vii) Machine maintenance (viii) Computer Department
Answers:
(i) Skimming pricing. (ii) Dual plan (iii)Net present value.
(iv)The factors involved in decision relating to expansion of capacity are enumerated as below :
(i) Additional fixed overheads involved should be considered.
(ii) Possible decrease in selling price due to increase production capacity.
(iii) Whether the demand is sufficient to absorb the increase production.
(vi) Service Sector Cost Unit
(i) Hotel Bed-nights available or occupied
(ii) School Student hours or no. of full time students
(iii) Hospital Patient-day / Room-day
(iv) Accounting firm Client hours
(v) Transport Passenger-Kms, or Quintal km or tonne-km
(vi) Staff Canteen No. of meals provided or no. of staff
(vii) Machine maintenance Maintenance hours to user departments
(viii) Computer Department Computer time to user departments.

18. The marginal costing convention of profit is more relevant to decision-making than the absorption
costing convention because
(A) So long as stock levels are rising, marginal costing gives a more conservative impression of
profit than does absorption costing.
(B) When stock levels are falling, the profit disclosed by marginal costing is less influenced by
costs from the previous period than is the case with absorption costing.
(C) Marginal costing provides a version of profit that relates only to those costs the level of which
are influenced by the matters being decided upon.
(D) Marginal costing provides a valuation of stock that conforms with current accounting standards
relevant to the preparation of published accounts.

Answer:
(A), (B) and (C) are all correct statements under most circumstances, but it is (C) that explains why
the marginal costing convention is most applicable to decision-making. (D) is a false statement since
it is absorption costing that is consistent with current accounting standards.

19. The use of predetermined overhead absorption rates is generally favoured by management
accountants because
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(A) It allows product costs to be determined before the end of a given accounting period.
(B) It avoids the over-or under-absorption of overheads.
(C) It provides a more conservative version of product costs.
(D) It relates more to the activities that give rise to overhead costs than do more traditional
methods of overhead absorption. Answer: (A).

20. Which of the following statements about a PV chart are true?

(a) The profit line passes through the origin.
(b) Other things being equal, the angle of the profit line becomes steeper when the selling price
increases.
(c) Contribution cannot be read directly from the chart.
(d) The point where the profit line crosses the vertical axis is the breakeven point.
(e) Fixed costs are shown as a line parallel to the horizontal axis.
Solution
(a) False. The profit line passes through the breakeven point on the horizontal axis, and cuts the
vertical axis at the point where the loss is equal to the fixed costs.

(b) True. Profits increase at a faster rate if the selling price is higher.
(c) True. A contribution breakeven chart is needed for this.
(d) False. The breakeven point is where the profit line cuts the horizontal axis.
(c) False. No fixed cost line is shown on a PV chart.

21. Delete as appropriate.: If a material stock item is regularly used in a business, the relevant cost of
using the item for a particular job is its original purchase price/replacement price.
Solution: If a material stock item is regularly used in a business, the relevant cost of using the item
for a particular job is its replacement price.

22. Put the following tasks in the correct sequence for deciding on the optimum production plan when a
limiting factor exists.
 Rank the products according to the contribution per unit of limiting factor used.
 Calculate each product’s contribution per unit of limiting factor used.
 Identify the limiting factor.
 Allocate the limited resource according to the ranking.

Solution:
1. Identify the limiting factor.
2. Calculate each product’s contribution per unit of limiting factor used.
3. Rank the products according to the contribution per unit of limiting factor used.
4. Allocate the limited resource according to the ranking.

23. Definition 1: ‘A system that converts a production schedule into a listing of materials and components
required to meet the schedule so that items are available when needed.’
Definition 2: ‘An accounting system that focuses on ways by which the maximum return per unit of
bottleneck activity can be achieved.’
Which of the following pairs of terms correctly matches definitions 1 and 2 above?
Definition 1 Definition 2
(A) Manufacturing resources planning (MRP2) Backflush accounting
(B) Material requirements planning (MRP1) Throughput accounting
(C) Material requirements planning (MRP1) Theory of constraints
(D) Supply chain management Throughput accounting
Answer: The correct answer is (B).
24. Which of the following statements is/are true?
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(i) Enterprise Resource Planning (ERP) systems use complex computer systems, usually
comprehensive databases, to provide plans for every aspect of a business.
(ii) Flexible Manufacturing Systems (FMS) are simple systems with low levels of automation that
offer great flexibility through a skilled workforce working in teams.
(iii) Just-in-time (JIT) purchasing requires the purchasing of large quantities of inventory items so
that they are available immediately when they are needed in the production process.

(A) (i) only, (B)(i) and (ii) only (C)(i) and (iii) only (D) (ii) and (iii) only
Solution: The correct answer (A).
25. If the budgeted fixed costs increase, the gradient of the line plotted on the budgeted Profit/Volume
(P/V) chart will
(A)Increase. (B)Decrease. (C)Not change. (D) Become curvi-linear.
Solution: Therefore the correct answer is (C).
26. Overheads will always be over-absorbed when
(A) actual output is higher than budgeted output.
(B) actual overheads incurred are higher than the amount absorbed.
(C) actual overheads incurred are lower than the amount absorbed.
(D) budgeted overheads are lower than the overheads absorbed.
Solution: The correct answer is (C).

27. An incremental budgeting system is:

(A) a system that budgets only for the extra costs associated with a particular plan.
(B) a system that budgets for the variable manufacturing costs only.
(C) a system that prepares budgets only after the manager responsible has justified the continuation
of the relevant activity.
(D) a system that prepares budgets by adjusting the previous year’s values by expected changes in
volumes of activity and price/inflation effects.
Solution: The correct answer is (D).

28. Which of the following perspectives are encompassed in a balanced scorecard?

(i) customer perspective (ii) financial perspective (iii) supplier perspective.

(A) (i) and (ii) only (B) (i) and (iii) only (C) (ii) and (iii) only (D) (i), (ii) and (iii)
Solution: The correct answer is (A).
29. Activity-based costing is
(A) a method of total costing which attributes costs to cost units using multiple activity drivers;
(B) a method of costing which is used to recognise the effects of changes in output activity and their
effect on total costs;
(C) a method of costing which is used to calculate the cost per unit in organisations which have only
one single activity;
(D) a method of cost accounting which derives unit costs according to planned outputs.
Solution: The correct answer is (A).

30. In the context of quality costs, training costs and reworking costs are classified as:
Training costsReworking costs
(A) Prevention cost internal failure costs
(B) internal failure costs internal failure costs
(C) internal failure costs external failure costs
(D) prevention costs external failure costs
Solution: The correct answer is (A).
31. In a TQM environment, external benchmarking is preferred to standard costing as a performance
measurement technique because:
(A) standard costs quickly become obsolete;
(B) TQM emphasises continuous improvement and reference to a predetermined internal standard
gives no incentive to improve;
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(C) TQM places an emphasis on employee empowerment, and the concept of a standard cost is
alien to this;
(D) the use of standard costs is only possible in a traditional mass-production industry.
Solution: The correct answer is (B).

32. Zero-based budgeting is best defined as:

(A) a method of budgeting based on cash flow rather than profit;
(B) an approach to budgeting that assumes all costs to be variable in the long term;
(C) a method of performance evaluation using benchmarks linked to strategic objectives;
(D) an approach that requires each activity to be evaluated and justified as if it were being
undertaken for the first time. Solution: The correct answer is (D).

33. Which of the following definitions best describes ‘Zero-Based Budgeting’?

(A) A method of budgeting where an attempt is made to make the expenditure under each cost
heading as close to zero as possible.
(B) A method of budgeting whereby all activities are re-evaluated each time a budget if formulated.
(C) A method of budgeting that recognises the difference between the behaviour of fixed and
variable costs with respect to changes in output, and the budget is designed to change
appropriately with such fluctuations.
(D) A method of budgeting where the sum of revenues and expenditures in each budget centre must
equal zero. Solution: The correct answer is (B).

34. Copenhagen plc is an insurance company. Recently, there has been concern that too many
quotations have been sent to clients either late or containing errors. The department concerned has
responded that it is understaffed, and a high proportion of current staff has recently joined the firm.
The performance of this department is to be carefully monitored.
Which ONE of the following non-financial performance indicators would not be an appropriate
measure to monitor and improve the department’s performance?
(A) Percentage of quotations found to contain errors when checked.
(B) Percentage of quotations not issued within company policy of three working days.
(C) Percentage of department’s quota of staff actually employed.
(D) Percentage of budgeted number of quotations actually issued. Solution: (D).

35. Which of the following statements are true?

(i) A flexible budget can be used to control operational efficiency.
(ii) Incremental budgeting can be defined as a system of budgetary planning and control that
measures the additional costs that are incurred when there are unplanned extra units of activity.
(iii) Rolling budgets review and, if necessary, revise the budget for the next quarter to ensure that
budgets remain relevant for the remainder of the accounting period.
(A) (i) and (ii) only (B) (ii) and (iii) only (C) (iii) only (D) (i) only
Solution: The correct answer is (D).

36. The fixed overhead volume variance is defined as

(A) the difference between the budgeted value of the fixed overheads and the standard fixed
overheads absorbed by actual production;
(B) the difference between the standard fixed overhead cost specified for the production achieved,
and the actual fixed overhead cost incurred;
(C) the difference between budgeted and actual fixed overhead expenditure;
(D) the difference between the standard fixed overhead cost specified in the original budget and the
same volume of fixed overheads, but at the actual prices incurred.
Solution: The correct answer is (A).
37. Definition A: ‘A technique where the primary goal is to maximise throughput while simultaneously
maintaining or decreasing inventory and operating costs.’
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Definition B: ‘A system whose objective is to produce or procure products or components as they are
required by a customer or for use, rather than for inventory.’
Which of the following pairs of terms correctly matches the definitions A and B above?
Definition A Definition B
(A) Manufacturing resource planning Just-in-time
(B) Enterprise resource planning Material requirement planning
(C) Optimised production technology Enterprise resource planning
(D) Optimised production technology Just-in-time
Solution: The correct answer is (D).

38. Which of the following statements is / are true?

(i) Computer-integrated manufacturing (CIM) brings together advanced manufacturing technology
and modern quality control into a single computerised coherent system.
(ii) Flexible manufacturing systems (FMS) are simple systems with low levels of automation that
offer great flexibility through a skilled workforce working in teams.
(iii) Electronic data interchange (EDI) is primarily designed to allow the operating units in an
organisation to communicate immediately and automatically with the sales and purchasing
functions within the organisation.
(A) (i) only (B) (i) and (ii) only (C) (i) and (iii) only (D) (ii) and (iii) only
Solution: The correct answer is (A).

39. Which of the following is a correct definition of activity-based management?

(A) An approach to the costing and monitoring of activities which involves tracing resource
consumption and costing final outputs. Resources are assigned to activities and activities to
cost objects based on consumption estimates. The latter utilise cost drivers to attach activity
costs to outputs.
(B) The identification and evaluation of the activity drivers used to trace the cost of activities to cost
objects. It may also involve selecting activity drivers with potential to contribute to the cost
management function with particular reference to cost reduction.
(C) A method of budgeting based on an activity framework and utilising cost driver data in the
budget-setting and variance feedback processes.
(D) A system of management which uses activity-based cost information for a variety of purposes
including cost reduction, cost modelling and customer profitability analysis.
(E) A grouping of all cost elements associated with an activity.
Solution: Answer: (D)
ABM uses the information provided by an ABC analysis to improve organisational profitability.
Option (A) defines ABC Option (B) defines activity driver analysis
Option (C) defines activity-based budgeting
Option (E) defines an activity cost pool

40. In an ABC system, which of the following is likely to be classified as a batch level activity?
(A) Machine set-up (B)Product design (C) Inspection of every item produced
(D) Production manager’s work (E) Advertising. Solution: Answer: (A)

Machine set-up costs are likely to be driven by the number of batches produced; therefore this is a
batch level activity. Product design (B) is a product level activity. The inspection of every item
produced (C) is a unit level activity. The production manager’s work cannot be related to a particular
product line; therefore this is a facility level activity. Advertising of individual products would be a
product level activity. If the advertising is concerned with promoting the company’s name then this
would be a facility level activity.

41. AB plc is a supermarket group which incurs the following costs:

(i) the bought-in price of the good;
(ii) inventory financing costs;
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(iii) shelf refilling costs;
(iv) costs of repacking or ‘pack out’ prior to storage before sale.
AB plc’s calculation of direct product profit (DPP) would include
(A) all of the above costs (B) all of the above costs except (ii)
(C) all of the above costs except (iv) (D) costs (i) and (iii) only (E) cost (i) only.
Solution: Answer: (A). All of the costs described can be identified with specific goods and would be
deducted from the selling price to determine the direct product profit.

42. When building up the cost of a product or service using activity-based costing, which of the following
would NOT be used as levels of classification?
(i) unit; (ii) batch; (iii) value added; (iv) product; (v) non-value added; (vi) facility.
(A) (ii) and (iii) (B) (iii) and (iv) (C) (iii) and (v) (D) (iii), (iv) and (vi)
(E) (v) and (vi). Solution: Answer: (C)
The four generally accepted categories of activity are unit level activities, batch level activities,
product level activities and facility level activities.

43. Which feature distinguishes backflush accounting from other systems?

(A) Labour costs are not charged to the units produced.
(B) Costs are attached when output is completed or sold.
(C) Cost records reflect the flow of work through the production process.
(D) Entries are not made until the customer pays for goods purchased.
(E) Material entries are made when the material is received and moved.
Solution: Answer (B). Backflush accounting is a method of costing associated with JIT. It delays the
recording of costs until after the events have taken place. The recording of costs may be triggered
when goods are transferred to finished goods stock or, in a true JIT system, when goods are sold.

44. The adoption of JIT normally requires which one of the following factors to increase:
(A) stock levels; (B) work-in-progress levels; (C) batch sizes; (D) quality standard.

Solution: Answer: (D). An increase in quality standards is one of the key factors that allows the other
items listed to be reduced..

45. In the practice of ABTs, a cost driver is:

(A) a reduction in unit cost without any loss of value;
(B) a factor that causes the total cost of an activity to change;
(C) the cost of converting raw materials into finished goods;
(D) a fee paid to the consultants who designed the ABT
Solution: Answer: (B)
46. Functional analysis is:
(A) an approach to the construction of budgets around the functions within a business;
(B) an approach to the examination of the specified purpose of a product;
(C) the separation of the materials mixture variance into component parts;
(D) a method of appraising the performance of cost centres.
Solution: Answer: (B)
47. When comparing the performance of two factories, one of which is owned and the other rented, the
inclusion of rent as an expense in the profit statement of the factory owned is known as the inclusion
of:
(A) a relevant cost; (B) a notional cost; (C) a controllable cost; (D) an indirect cost.
Solution: Answer: (B)
48. Activity-based costing is:
(A) a method of total costing which attributes costs to cost units using multiple activity drivers;
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(B) a method of costing which is used to recognise the effects of changes in output activity and
their effect on total costs;
(C) a method of costing which is used to calculate the cost per unit in organisations which have
only one single activity;
(D) a method of cost accounting which derives unit costs according to planned outputs.
Solution: Answer (A)
49. In the context of quality costs, training cost and reworking costs are classified as:
Training costs Reworking costs

(A) prevention costs internal failure costs

(B) internal failure costs internal failure costs
(C) internal failure costs external failure costs
(D) prevention costs external failure costs
Solution: Answer (A)
50. In a TQM environment, external benchmarking is preferred to standard costing as a performance
measurement technique because:
(A) standard costs quickly become obsolete;
(B) TQM emphasises continuous improvement and reference to a predetermined internal standard
gives no incentive to improve;
(C) TQM place an emphasis on employee empowerment, and the concept of a standard cost is
alien to this;
(D) The use of standard costs is only possible in a traditional mass-production industry.
Solution: Answer (B)
51. Which of the following are required to determine the breakeven sales value in a multi-product
manufacturing environment?
(i) individual product gross contribution to sales ratios;
(ii) the general fixed cost;
(iii) the product-specific fixed cost;
(iv) the product mix ratio;
(v) the method of apportionment of general fixed costs.
(A) (i), (ii) (iii) and (iv) only. (B) (i), (iii) and (iv) only. (C) (i), (ii) and (iv) only (D) All of them.
Solution: The answer is (A).
52. State whether the following statements given bellow are ‘True’ or ‘False’. If True, simply rewrite the
given statement . If False, state it as False and rewrite the correct statement
(i) Value Chain Concept and Value Added Concepts are fundamentally same.
(ii) Value Analysis Process is a less important tool than Function Analysis System Technique.
(iii) Effector is another name for Management Information System.
(iv) JIT manufacturing based on ‘Push Through Philosophy’, helps to provide the right parts at the
right time and in right quantity.
(v) A company’s approach to make or buy decision depends on whether the company is operating
at or below normal volumes.
Answer:
(i) False. Value Chain concept is fundamentally different from the Value Added Concept.
(ii) True. Value Analysis (VA) Process is less important tool than Function Analysis System
Technique (FAST)
(iii) False. ‘Detector’ is another name for Management Information System (MIS).
(iv) False. JIT manufacturing operates as a demand-pull system, producing on demand i.e.,
making to order.
(v) False. A co’s approach to make or buy decision involves an analysis of avoidable costs.
53. Fill in the blanks with the most appropriate word(s) out of the options indicated in the bracket against
each statement:
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(i) The adoption of JIT normally requires to improve ________ (Production time/Quality Standard).
(ii) FAST or Function Analysis System Technique is an evolution of the ________ (Quality Function
Deployment/Value Analysis) process.
(iii) One of the ten principles of Lean Supply Chain is to ‘make your customers and suppliers your
real ________’ (Friends/Partners).
(iv) _________ (Internets/Intranets) can help users to locate and view information faster.
(v) _________ A __________ (Management Culture/Management Style/Organizational Structure)
consist of shared values, beliefs and norms of organization.

Answer
(i) The adoption of JIT normally requires to improve Quality Standard.
(ii) Fast or Function Analysis System Technique is an evolution of the Quality Function
Development process.
(iii) One of the ten principles of Lean Supply Chain is to ‘make your customers and suppliers your
real Partners.
(iv) Intranets can help users to locate and view information faster.
(v) A Management Culture consists of shared values, beliefs and norms of organization.

54. State whether the following statements given below are ‘True’ or ‘False’ with justifications for your
answer. If False, state the correct statement. No credit will be given for merely stating –‘True’/‘False’.
(i) ERP bridges the information gap across the organization.
(ii) Target Costing reduces the overall cost of a product over its entire life-cycle with the help of
production, engineering, research and design.
(iii) JIT manufacturing, based as it is on ‘Push through’ philosophy, helps to provide the right parts
at the right time in right quantity.
(iv) A Balanced Score Card studies the performance of management by comparing a financial
achievement with the amount spent thereon.
(v) The key factors of ‘Theory of constraints’ is contribution and profit.

Answer:
(i) True.
The ERP System, which provides a platform for integrating the enterprises wide data base, into
a meaningful management information system for decision making, becomes a very useful tool
in the hands of the Cost Manager.
(ii) True.
Target Costing aims to reduce the cost of product at planning, development and design stage
of a product rather than production stage.
(iii) False.

JIT manufacturing operates as a demand-pull system, producing on demand i.e., making to

order.
(iv) False.
Balanced Score Card does not focus solely on achieving financial objectives. It is an approach
which provides information to management to assist in strategic policy formulation and
achievement.
(v) False.
The key factors of ‘Theory of Constraints’ are Throughput, Inventory and operating expenses.
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55. State whether the following statements are ‘True’ or False’. If false, you are to put up the correct
statement. No credit will be given for merely stating ‘False’. If ‘Right’, just mention-‘Right’. You need
not rewrite the statement:
(i) Value Analysis process is a less important tool than Function Analysis System Technique.
(ii) The term Value has four different meanings- Exchange value, cost value, use value and wealth
value.
(iii) The Balance Score Card puts more stress on financial parameters than on non-financial
parameters, since its objective is the growth of the organization.
(iv) The Matrix Organization structure is suitable for large projects.
(v) Akio Morita is credited with pioneering the cost approach of target costing.

Answer:
(i) True.
(ii) False. The term Value has four different meanings- Exchange value, cost value, use value and
Esteem value.
(iii) False. The Balance Score Card puts more stress on non-financial parameters than on financial
parameters because it is these non-financial parameters measures are guides to the actual
performance.
(iv) False. The Matrix Organization structures are not suitable for large projects, since they cannot
fully support decentralized set-ups.
(v) True.